The global economy and markets have come a long way since the financial crisis. Output in most major economies (in nominal terms) is higher than it was pre-crisis, as are asset prices. The specter of deflation is starting to fade as economic slack decreases and commodity prices stabilize. Extraordinary central bank policies, while controversial, have played a significant role in getting us here.

Looking forward, it is our view that the world remains in The New Neutral, and importantly that asset markets now broadly reflect this development in their prices.

All this has significant ramifications for the evolution of asset prices and for how investors should approach multi-asset portfolios over the next three to five years, which we refer to as the secular horizon.

We reaffirmed the New Neutral thesis in May, when our investment professionals from across the globe gathered in Newport Beach for our Secular Forum to debate the long-term outlook for the global economy and to identify and assess key variables, trends and catalysts that may affect valuations and returns across global asset classes. We came away from the forum with some important insights, which Daniel Ivascyn, Richard Clarida and Andrew Balls describe in PIMCO's Secular Outlook, "The New Neutral Revisited."

At the center of our New Neutral thesis is the belief that even as central banks raise rates, they will do so slowly and prudently, and that the neutral rate over the coming cycle – meaning a rate that is neither stimulative nor contractionary – will be lower than in cycles past (a rough benchmark for the U.S. is closer to a 2% average policy rate than the traditional 4% assumed by many). We also don't foresee an inflation problem, even as we move away from an era of extremely limited price increases. Low interest rates and moderate inflation together support a muted but prolonged business cycle, and we believe this combination helps to sustain current asset valuations.

So why does our New Neutral thesis have significant ramifications for multi-asset investors over the secular horizon? We would argue that the tailwind from ever-lower policy rates and contracting term premia witnessed over the past 30 years is largely past us. Moreover, current valuations – as most assets already price in the reality of lower rates – are likely to constrain potential returns going forward.

Therefore investors must adjust to a world where returns on asset classes and the paradigm for constructing optimal portfolios over the next five years are unlikely to resemble those of the last five or even 30 years. Investors will need to be more dynamic and tactical in their overall asset allocations, and they should approach portfolio construction with even more differentiation as they allocate risk to individual positions. It is still possible to achieve compelling returns, but we believe the role of active portfolio management has become more important, and more necessary, than ever.

The New Neutral

For the next three to five years, even as monetary policymakers seek to normalize interest rates they will generally set short-term rates at levels below the rates that prevailed before the global financial crisis. Also in this New Neutral world, countries will converge to slower trend growth trajectories. Since PIMCO introduced The New Neutral secular view in May 2014, the construct has been priced in to financial markets.

The fading discount rate boost

Let's start with restating the essential point: The tailwind to asset classes from ever-lower interest rates is largely behind us. Over the past several years, lower risk-free rates from aggressive central bank policies accompanied by dropping inflation created a ''denominator effect" by pushing discount rates lower, which in turn led to higher valuations of assets. The discount rate applicable to future cash flows, regardless of the asset class, starts with the real "risk-free rate." The appropriate discount rate for each asset class can be modeled as the risk-free rate with an additional risk premium associated with its position in the capital structure and exposures to risk factors: for example, inflation and term premia for sovereign bonds, default and liquidity premia for credit, and equity risk premium for equities – each building off the risk-free discount rate. As risk-free rates drifted lower over a period of many decades, not only did the present value of future cash flows increase in the sovereign bond market, valuations increased broadly across all asset classes as growth expectations declined by less than the drop in risk-free rates.

So where are we headed? In fixed income, we do not see significantly higher bond yields over the next three to five years. Rather, policy rates are expected to rise gradually over the secular horizon. This change, from steadily falling discount rates to stable or, in many cases, modestly rising discount rates, will likely have substantial consequences:first, via lower expected returns, and second, on portfolio construction.

In this new regime, rigid ''buy-and-hold" strategies may not work as well as they did in the past. A prime example is the recently popularized "risk parity" approach to asset allocation, a strategy by which portfolio allocations are sized in order to ensure the risk contribution from stocks, bonds and inflation-related assets is equal, or at parity. Given bonds generally have lower volatility than stocks and other assets, risk parity strategies systematically use leverage to increase risk exposure to the bond component. Over the past several years, markets have been generally friendly to these strategies as bond term premia compressed and volatility became subdued. However, they may now face headwinds as volatility resets and interest rate trends reverse, necessitating an active approach when managing these strategies. Moreover, studies have shown that the negative correlation between stocks and bonds (one of the key tenets behind this approach) tends to be greater when yields are falling than when yields are rising, which has significant implications for portfolio construction and diversification.

It seems clear that in the market environment we are facing, tactical asset allocation and robust portfolio construction will become even more important as correlations become increasingly unstable and dispersion increases across asset class returns. In this new regime, region, country and sector selection and bottom-up relative value strategies will have to do more of the heavy lifting to help offset either the end or reversal of the tailwind of declining discount rates.

Forecasting long-term returns

If asset valuations are full and price returns are likely to be lower overall, where do we find attractive opportunities? The New Neutral hypothesis offers a guide. Weaker growth potential and waning tailwinds from demographic trends will likely incentivize central bankers of highly levered, developed economies to raise rates in a slow and prudent manner, not veering far from the zero bound and keeping policy rates below previous long-term averages. We believe this will contribute to a longer economic cycle.

In this scenario, investors should expect low but positive returns from most developed market asset classes, with equities and credit outperforming government bonds and cash. Therefore, despite corporate bond yields seeming low and equity multiples seeming high, we do not see either market as overvalued or primed for a lasting correction. Investors may wish to add emphasis to the riskier asset classes in their overall allocation given our belief that lower yields and higher valuation multiples should be viewed through the lens that rates will be lower than in previous decades even as they creep upward.

For example, as we consider equities in our asset allocation portfolios, we estimate the current equity risk premium in the U.S. to be 3.9% in real terms, which is very close to its long-term average of 4.0% and higher than the 3.5% average observed during economic expansions. This suggests a fair premium relative to U.S. bonds and one with room to compress as economic strength continues to improve. Moreover, in seeking to outperform, one can always look for companies, sectors or even countries where earnings growth can positively impact prices and valuations.

Next, consider U.S. investment grade credit: Spreads relative to U.S. Treasuries, a measure that shows the additional premium bond investors demand as compensation for default risk, are not especially narrow relative to history, particularly for this stage of the business cycle. The current spread over the risk- free rate (option-adjusted spread, or OAS) is 137 basis points (bps), slightly narrower than the 40-year average of138 bps but wider than levels typically observed during economic expansions (132 bps on average in first half expansions, and 110 bps on average in second half expansions).

For global markets, our general estimates for long-term returns based upon our New Neutral thesis are shown below. These estimates take into account current valuations, carry and where we believe valuations may be headed based upon our macroeconomic outlook.

Turning to emerging markets (EM), we believe that on average these sectors should outperform comparable developed market sectors over the secular horizon, but are likely to do so with higher volatility and other risks that must be considered.

As in the developed markets, lower yields have been a tremendous supporter of performance for EM assets following the financial crisis. However, in the past few years, emerging markets have gone through numerous challenges that have led to generally disappointing performance. Lower growth, lower commodity prices, weak exports and a strong U.S. dollar recently have been serious headwinds. The silver lining of the recent challenges, however, is that EM assets generally offer more favorable starting valuations.

EM growth, which is expected to be higher than in developed markets, also helps valuations appear attractive. Add in the higher level of investments and productivity enhancements, and we have a favorable backdrop for attractive secular returns from emerging markets.

Thus far we have described the likely impact of The New Neutral on asset prices and their forward return potential, but as we mentioned at the outset, it is imperative to survey the markets and identify pockets of potentially more attractively priced securities that may deliver more attractive risk/return tradeoffs. In developed markets, to name a few examples, we believe global equities outside of the U.S. offer better forward return potential than those within. Across credit sectors we see superior opportunities in European financial and U.S. housing sectors. With respect to government debt, we generally find inflation-linked securities more attractive than their nominal counterparts.

In EM, our theme of differentiation and dynamic management of portfolio positioning is even more important. No single EM country or asset class is likely to deliver these "average" long-term returns. Secular winners and losers will be decided as a function of initial conditions as well as country-specific monetary and fiscal policies. For countries or companies in emerging markets to attract scarcer global capital, they will need to demonstrate superior return potential that helps to compensate for their lack of liquidity and greater volatility. Policymakers and corporate managers will need to take the steps necessary to lead their countries and companies toward sustainable economic expansion. Successful investors will have to work to identify these potential winners: In the New Neutral world of muted growth, the twin engines of export driven growth or terms-of-trade shock may not work going forward.

Capital Market Return Assumptions for Strategic Asset Allocation

Our long-term estimated returns are based on a structured internal survey, which queries senior portfolio managers (both generalists and specialists) for their forecasts for key markets. The survey is overseen by the asset allocation and the analytics teams.

The key inputs that are obtained through the survey process are forecasts for these data:

  • Real GDP growth and inflation globally
  • Equity valuations, dividend yields and earnings growth
  • Nominal and real yield curves globally
  • Foreign exchange rates against the U.S. dollar
  • Investment grade and high yield credit spread levels, expected defaults and downgrades
  • Sovereign credit spreads

A set of robust, well-established valuation models that map current market variables to expected returns serves as an anchor for the inputs in the survey process. For equities, country-specific cyclically adjusted earnings yields and estimates of equity risk premia over the local real interest rate relative to historical levels provide the most important analytical valuation anchor. Expected earnings growth is based on per capita real GDP growth estimates. For interest rates, the current yield level, the spread between current yields and forward rates alongside model-based estimates of long-term fair value for nominal and real yields are the most important analytical inputs which guide the expected long-term yields and model-based returns. For credit, the level of the current credit spread relative to history (adjusted for leverage ratios and composition across sectors and ratings quality) and historical defaults and downgrade losses are combined into a model-based forecast of future spreads and returns for both investment grade and high yield. For FX/currencies, real interest differentials are combined with a mean reversion toward purchasing power parity (PPP)-based fair value across countries to determine a model- based FX spot appreciation/depreciation and overall FX return.

Asset Allocation Themes for Multi-Asset Portfolios
With the tailwind from ever-lower policy rates and term premia compression behind us, rather than see cause for alarm, investors should consider this a time to (1) refocus portfolio construction, (2) revisit sources of value through active management and (3) be judicious in asset allocation decisions. We believe investors will be best served if they consider opportunities across asset classes and throughout the globe.



In our asset allocation portfolios, our investment decisions are made using
a four-pronged framework:

  • We begin by gauging where in the globe macroeconomic conditions or policy actions are likely to produce the biggest surprises. These factors interact with macroeconomic fundamentals in ways that can have meaningful effects on asset returns.

  • Then we conduct a rigorous analysis of cross-asset valuations and risk premia to inform our decisions on what to own long-term. This helps us determine our strategic allocations to various regions and asset classes.

  • Next, we meet and debate often to assess short-term factors such as momentum, liquidity and investor flows, which

  • Finally, correlation and risk management considerations  are incorporated to scale exposures.

Overall Risk

  • Despite the waning tailwind of declining discount rates on asset class returns, we believe investors should not only stay invested, but look for opportunities to strategically overweight risk positions over the long term. Moderate global growth and a gradual upward path to interest rate levels lower than in previous cycles should be supportive of asset classes, though support is more tilted to providing a floor than providing a boost.


    Secular Opportunities:
  • A global survey of equity risk premia suggests fair to attractive valuations relative to bonds and recent history
  • Exposure in Europe and Japan appear attractive given policy efforts that are stimulating growth, the levels of dividend yields and current valuations
  • Emerging markets, particularly those in Asia, offer attractive opportunities for strategic overweights given macro trends, supportive policy and reforms, and levels of equity risk premia particularly when compared to recent history


    Secular Opportunities:
  • Core fixed income retains its important role in a multi-asset portfolio to provide diversification and income
  • We are wary of exposure to interest rates in developed markets as rates are low and poised to rise
  • There are interesting opportunities in select EM countries, including Mexico and Brazil


    Secular Opportunities:
  • Despite low all-in yields across credit sectors, spreads above government rates remain within fair to attractive levels
  • We find specific opportunities such as European financials and U.S. housing-related credits most attractive
  • A deeper appreciation for potential liquidity is needed given less inventory capacity at banks due to global banking regulations

Real Assets

    Secular Opportunities:
  • Global inflationary trends may be poised to reverse and gain positive momentum, bolstering the case for real assets
  • Inflation-linked bonds are particularly attractive as their prices continue to imply very low inflation premia when compared with nominal bonds
  • Differentiation and tactical agility will be necessary to extract attractive returns from commodities as we believe supply and demand are generally matched


    Secular Opportunities:
  • We remain bullish on the U.S. dollar, and thus underweight international and emerging market currencies, given the divergence of Fed policy with most global central banks
  • There are select opportunities in higher-yielding EM currencies like the Indian rupee; investors should nevertheless be wary of the potential for heightened volatility

Global Equities

Positive long-term outlook

We are generally constructive on the potential for equities to deliver long- term returns, though (as noted above) our 10-year forecast for developed market equities is in the modest 4%-5% range, and slightly higher for emerging markets (which include additional idiosyncrasies and risks).

The factors favoring equities include muted inflation, an extended business cycle and low discount rates which, if they move up, will likely do so slowly and to levels still low by historical standards.

Looking around the globe, European equities appear attractive over the secular horizon. In addition to the broader developments discussed, the trend toward increased dividend payout and a higher equity risk premium provide a good backdrop for superior returns. European equities offer high levels of earnings yields and valuations are lower relative to history. We think a resolution of the Greece crisis would remove a source of uncertainty and allow the market to outperform.

European financials may be a good secular choice in equity space, as well as hybrid securities or subordinated debt. We believe European banks are now far advanced in raising capital and in reaching some degree of normalization in yields, and the shape of the yield curve should lead to higher profitability, which is already buoyed by the cheap funding the European Central Bank (ECB) continues to provide through sustained quantitative easing.

In Asia, Japanese equities also offer strong secular return prospects. They have some of the best earnings growth momentum in the developed markets and stand to further benefit from the quantitative easing and structural reforms that are improving corporate governance and profitability.

We also favor equities in China and India: Both countries have embarked on secularly far-reaching reform agendas that should diminish vulnerabilities and unleash value. In particular, we should point out that the "bubble" and extreme valuations are confined to a small part of the Chinese market and recent volatility affords attractive entry for long-term investors into the more reasonably valued HSCEI (H shares).

Global Fixed Income

Differentiation Is Critical in Anchor Asset Class

Fixed income should remain a cornerstone of multi-asset portfolios for the foreseeable future as The New Neutral remains an anchor for fixed income valuations. However, ahead of the first Fed hike in almost 10 years, we are cautious on developed market duration in our portfolios and encourage investors to consider the full spectrum of global opportunities in fixed income.

In the developed markets we are likely to see term premium return to yield curves. There are two potential scenario