PIMCO on Tuesday released its asset allocation strategy for the next three to five years, saying the world is in a "New Neutral" environment.
The authors, Mihir Worah, chief investment officer focusing on real return and asset allocation, and Geraldine Sundstrom, managing director, argue that central banks will raise rates "slowly and prudently" and that the neutral rate—one that is "neither stimulative nor contractionary"—will be lower than it has in the past.
They predict inflation will not be a significant problem and that current valuations will "constrain potential returns going forward."
Consequently, investors need to get used to an environment where returns and optimal portfolio construction doesn't look like it has in the past. "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," the authors wrote.
The slow increase in rates will lead to a longer economic cycle with low but positive returns in most developed market asset classes, the authors predict. They estimate equities and credit will outperform government bonds and cash, with the current equity risk premium at 3.9% and the current spread between U.S. investment grade credit and Treasuries at 137 basis points.
"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," they wrote.
They recommended that investors overweight to riskier asset classes in their overall allocation to account for lower yields and higher valuation multiples.
European and Japanese equities are expected to do particularly well as increased dividend payouts and a higher equity risk premiums in Europe drive higher returns. Japanese equities have "some of the best earnings growth momentum in the developed markets" and quantitative easing and structural reform there is expected to improve corporate governance and profitability, too.
China and India are also bright spots, as both countries have implemented reform to reduce vulnerabilities. Regarding China, which has seen significant declines, the authors wrote, "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)."
