All Asset All Access: Managing Portfolios Amid Evolving Market Narratives

Rob Arnott, chairman of Research Affiliates, discusses the prospects of value-oriented strategies in a high inflation environment. Michele Mazzoleni, partner in the multi-asset strategies team at Research Affiliates, explains the framework and the evolution of the long-term asset class return models that inform the All Asset strategies. As always, their insights represent Research Affiliates’ views in the context of the PIMCO All Asset and All Asset All Authority funds. All Asset All Access is published quarterly.

Q: If a high inflation environment persists, how does Research Affiliates expect value-oriented equity strategies to fare?

Arnott: While the relationship is not perfect, historically value has tended to win in inflationary regimes, and win or lose in disinflationary regimes. Looking back over the past nine decades, we observe this pattern of results, as reflected in Figure 1. As many of our readers may be aware, I’m on the record for forecasting that a high inflation environment is likely to persist, especially given my view of the likelihood of owners’ equivalent rent (OER), comprising approximately one-third of the U.S. CPI (Consumer Price Index), escalating rapidly in the coming years. If history is a guide, value is likely to fare well in such an environment.

Figure 1 is a scatter plot chart showing decade-long spans from the 1930s through the 2010s, comparing each decade’s annualized U.S. CPI inflation (or deflation) on the Y axis with the decade’s annualized excess return (or loss) in value stocks on the X axis. The 2010s saw moderate annualized inflation of just below 2%, but also annualized negative excess returns in value stocks, around −2.7%. The 1930s were a period of deflation (−2% annualized) and very modest gains in value stocks (0.5%). The 1970s were are period of significant inflation and of excess performance in value stocks, with both above 7%. Further details are in the notes below the chart.Image Pop Up

From a portfolio perspective, I believe that ultimately, relative valuation trumps everything else. So, even in a scenario in which a high inflation environment doesn’t persist, the prospects of value markets and value-oriented strategies remain compelling. Why? Today the valuation of value stocks relative to growth stocks is as stretched as it was at the peak of the turn-of-the-millennium tech bubble. A narrowing spread should set the stage for potentially strong outperformance. With a current allocation of around 30% in value-oriented RAE strategies, the All Asset strategies should be well positioned to take advantage of this opportunity. At Research Affiliates, we believe we’re in the early stages of a major rebound of value in the years ahead.