Update. The Investment Balancing Act

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1 I / 2014 Update Allianz Global Investors Magazine for Institutional Clients The Investment Balancing Act The right combination of opportunity and risk has never been more important. But how do you find the best balance? OUTLOOK Will Deflation Follow Disinflation? Inflation Outlook for the Next Two Years STRATEGY Best Styles: Harvesting Risk Premium in Equity Investing FIXED INCOME Emerging Markets Debt

2 06 OUTLOOK Will Deflation Follow Disinflation? Inflation outlook for the next two years. 16 STRATEGY Best Styles: Harvesting Risk Premium in Equity Investing 24 FIXED INCOME Emerging Markets Debt SPOTLIGHTS News from the world of Allianz Global Investors 04 INTERVIEW Should private market investments be included in any institutional portfolio? 34

3 Update I/2014 EDITORIAL The Investment Balancing Act Dear Reader, A few weeks ago, the 5 th Allianz Global Investors Investment Forum took place in Hong Kong. During this event, investment experts discussed the investment outlook over the intermediate and long term, as well as the dominant themes on the capital markets. In this issue of Update Magazine, we address the most important issues that were considered there. For some time now, the public has been intensively debating whether Europe is threatened by deflation. Are we headed for a Japan experience? In that country there is now talk of two lost decades. Our chief economist, Stefan Hofrichter, argues that falling prices in some crisis-stricken European countries are part of the painful adjustment process. But he views the danger of a deflationary downward spiral for the Eurozone as being very low. This in turn means that the challenge for investors with a long-term outlook continues to be primarily how to obtain adequate returns in an up to now only slightly inflationary environment. To this end, equity exposure continues to be indispensable, in the opinion of Allianz Global Investors. Klaus Teloeken, our CIO Systematic Equity, outlines the proven Best Styles approach. This method provides a very successful allocation between various investment styles and has, in the past, been able to systematically achieve greater returns compared to equity benchmarks in various regions, coupled with an extremely low tracking error. Investments in emerging markets likewise continue to be a component of every well-diversified portfolio. Following a long period of essentially undiscriminating interest in emerging markets, the mood has recently changed as a result of price setbacks. Is the golden age of emerging market investments already over? Greg Saichin, our CIO for emerging market bonds, disagrees. It has always been smart to make discriminating investments in emerging markets. In this issue, he explains his team s investment process. This issue of Update Magazine is rounded off with an interview on the role of illiquid assets in institutional portfolios. Wolfgang Mader, Head of Asset Allocation Strategies at AllianzGI Global Solutions/risklab, and Olga Braun-Cangl, Senior Consultant at AllianzGI Global Solutions/Manager Research & Selection, respond to questions on private equity, privately placed loans and infrastructure investments as suitable portfolio diversifications for institutional investors. Here at Allianz Global Investors, we are convinced that the days of risk-free returns on the markets are over for the time being. This means that investors do not have any alternative to taking more risks in their capital investments in order to achieve their return goals. The greatest risk in capital investment today is not taking any risk. Active portfolio management and dynamic risk management are therefore more important than ever. I wish you an enjoyable and informative read. Sincerely, Michael Schütze Head of Corporates Deutschland

4 Spotlights News from the world of Allianz Global Investors Volume 6, Issue 2 Allianz Global Investors Insights February 2014 OPINION 4th Allianz Global Investors Investment Forum Our first Investment Forum took place in San Francisco in Since then, this Forum has gone on to become a highlight of the AllianzGI world. It serves as a source of inspiration, and as an opportunity to check whether our medium- to long-term investment outlook and themes are on the right track. Under the motto Taking smart risk to achieve active return, our investment experts met once again at our fourth Investment Forum this year in Hong Kong to take a look back at the past year, and discuss the investment outlook for OUTLOOK Allianz Global Investors Insights Based on a macroeconomic outlook, Andreas Utermann, Global CIO of Allianz Global Investors, shows which asset classes offer the best opportunities for active returns in an environment of continued low interest rates and inflation. Our research offers a particularly interesting look at the US oil market. Thanks to increasing oil production, the US is forecast to replace Saudi Arabia and Russia as the world s largest oil producer in What consequences could this development have for the US economy? An outlook on the US equities market and the Asian bond market rounds off the current issue of Allianz Global Investors Insights. READ MORE AT 4

5 Update I/2014 PRESS RELEASE Infrastructure Investment Allianz Global Investors will make a 175m investment in a major Scottish road project on behalf of its clients. AllianzGI has committed to acquire listed Project Bonds issued by Scot Roads Partnership Finance Limited, which will be used alongside a term loan from the European Investment Bank (EIB) and shareholder funding to finance the design, construction, operation and maintenance of roads forming part of the M8, M73, M74 Motorway Improvements Project in central Scotland. Commenting on the transaction, Adrian Jones from AllianzGI s infrastructure debt team, said: AllianzGI is delighted to be the first investment manager to make such an investment possible for a UK pension fund client. UK pension trustee, Stanhope Pension Trust Ltd is one of an increasing number of third party investors, alongside Allianz group entities, electing to invest via the AllianzGI infrastructure debt platform to gain access to this asset class. We expect the experience gained in achieving this milestone to stimulate the participation of more institutional investors in UK infrastructure to the benefit of both long term investors and the broader UK economy. We are particularly pleased to demonstrate that our funding solution is compatible with lending by the European Investment Bank, a major public sector funder of UK infrastructure, and that the deferred funding structure is capable of achieving an A- credit rating for the underlying investment. KNOWLEDGE Studies New studies are now available, fresh from the Global Capital Markets & Thematic Research workshop. The publication Strategic Asset Allocation in Times of Financial Repression takes a closer look at the key element that determines a portfolio s return: strategic asset allocation. Dr Wolfgang Mader and Dr Christian Schmitt from AllianzGI Global Solutions/risklab show readers the right way to achieve appropriate strategic investment planning in today s climate of financial repression. In the publication Cross-border Defined Contribution Plans in Europe, Wolfgang Deschka from AllianzGI Global Solutions presents a market overview of different ways of designing pension plans in various European countries. In the study Dynamic Risk Parity A smart way to manage risks, Dr Timo Teuber explains how risks can be evenly distributed in a portfolio. READ MORE AT 5

6 6 Outlook

7 Update I/2014 Will Deflation Follow Disinflation? Inflation Outlook for the Next Two Years In Europe and the United States, inflation rates have been dropping for about two years. At present, the average rate of inflation in the Eurozone is less than 1%, below 2% in the United States, and around 2% in the UK. In a few countries in the periphery of the Eurozone (Greece, Cyprus), prices have even fallen recently in comparison with the previous year. Only in Japan are inflation rates rising. AUTHOR: STEFAN HOFRICHTER The question that plagues investors is: will the trend of falling inflation rates in Europe and the US continue or will it even move over into deflation? In a few months or quarters will we see falling prices not only in a few countries of the Eurozone, but rather across Europe and possibly also in North America? This would have massive ramifications for investment decisions. Falling prices mean inadequate leeway for pass-through of price increases for enterprises, and thus pressure on margins and profits. In times of falling prices, the performance of stocks is negative, as the example of Japan has demonstrated. In addition, the high levels of corporate, household and government debt would increase in real terms, and debt problems would again intensify. In order to be able to assess the outlook for inflation, one must first understand why inflation rates in the industrialized nations have recently been falling. In our opinion, there are three important reasons for this. The three drivers behind the price trend Firstly, we find the western industrialized countries in an economic environment in which companies, private households and governments are trying to reduce their high levels of debt. This is a long, drawn-out process that is typically characterized by economic growth lasting several years and consequently also by moderate inflation. Specifically in the Eurozone, we are still at 7

8 OUTLOOK The greater the pressure on the currencies in the emerging markets becomes, the greater the feedback effects for the industrialized countries, both for aggregate demand and for inflation rates characterized by falling import prices. the beginning of this development, but in the US and the UK also, the deleveraging phase has not yet come to an end. We are continuing to expect trend growth in the western industrialized countries in the coming years which, however, will probably be lower compared with before the crisis. This argues initially for a continuing subdued price environment. The second reason for the continuing disinflation trend is closely tied to that outlined above. Employees in the western industrialized countries currently only have weak negotiating power. As a matter of fact, inflation contrary to widespread belief often runs ahead of rather than trailing wage rises. In other words: rising inflation would be possible even in the presence of moderate wage rises, but inflation can rise in the long run only if wage hikes eventually follow, and rising demand is generated through rising incomes, reinforcing the original inflationary impetus. However, in the current environment this is difficult to imagine. Quite the contrary, in fact. The current low growth in wages in the industrialized countries at present is still reinforcing the disinflationary trend. Thirdly, prices for internationally traded goods are currently under pressure. This applies above all to goods that are exported from emerging markets, and to raw materials. This development in itself is nothing out of the ordinary, and has been observed several times over past years. But against the background of recent upheavals in the emerging markets, and Japan s extremely expansive monetary policy, the risk of continued pressure on import prices in industrialized countries in the coming months should not be minimized. Monetary policy in Japan is resulting in a deterioration of the macro environment, in particular for the Asian emerging markets. This growth-inhibiting effect also means weaker demand for raw materials, producing an indirect effect on commodity-exporting countries, particularly in Latin America. 8

9 Update I/2014 Falling prices mean inadequate leeway for pass-through of price increases for enterprises, and thus pressure on margins and profits. 9

10 OUTLOOK 01 THE CASE AGAINST DEFLATION: ECONOMIC RECOVERY AND STABLE INFLATION EXPECTATIONS EMU Survey of Professional Forecasters: inflation in 2 years and 5 years 2.1% 2.0% 1.9% 1.8% 1.7% 1.6% 1.5% EMU SPF: CPI inflation next 5 years EMU SPF: CPI inflation next 2 years USA: Survey of Professional Forecasters inflation in 10 years, Michigan Survey: inflation in 5 years 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% SPF: CPI (Consumer Price Index) inflation next 10 years U. MICHIGAN: CPI (Consumer Price Index) inflation next 5 years Source : Datastream, Allianz GI Economics & Strategy, data as of January

11 Update I/2014 At Allianz Global Investors we are assuming that during 2014, and at the latest in 2015, inflation rates will not only stabilize, but will show a moderate rise. The greater the pressure on the currencies in the emerging markets becomes, the greater the feedback effects for the industrialized countries, both for aggregate demand and for inflation rates characterized by falling import prices. The forces described above will presumably also result in falling inflation rates in the western industrialized countries in the coming months. But at Allianz Global Investors we are assuming that during 2014, and at the latest in 2015, inflation rates will not only stabilize, but will show a moderate rise. In our opinion, there are several factors arguing for this which will act against the disinflationary forces, and prevent a slide into Japan-style deflation. One key argument is the cyclical recovery in the industrialized countries. While we are assuming only a low rate of growth during this year for Europe, which at best will be in line with trend growth (approx. 1.25% in the Eurozone), this represents a definite improvement in comparison with the preceding year, when the region was still in recession. For the US we expect significantly higher growth than in the preceding year, since the braking effects of a restrictive fiscal policy will be significantly lower this year. As in the past, stronger economic development should lead to a rise in inflation rates since, in macroeconomic terms, the difference between supply and demand is narrowing. (Chart 1) Stable long-term inflation expectations of around 2% also argue against the risk of deflation. This is crucial. If the opposite were the case, if companies and households were to defer expenditure into the future, economic growth would drop with negative effects on prices. Without a doubt, however, current inflation expectations are no cause for complacency, since trend changes in inflation rates usually come unexpectedly, and inflation expectations adjust only after a delay. This means fiscal policy is of special importance, since it can help stabilize inflation expectations through appropriate measures, such as large-scale purchases of bonds. (Chart 2) 11

12 OUTLOOK 02 THE CASE AGAINST DEFLATION: GLOBAL BROAD MONEY SUPPLY IN LINE WITH TREND NOMINAL GDP GROWTH Global broad money supply, year over year 8% 7% 6% 5% 4% 3% 2% 1% Q Q Q Q Q Q Q Q Q Q Q Q Q Source : Datastream, Allianz GI Economics & Strategy, data as of Q Monetary supply is within the scope The rate of growth in the global broad monetary supply we analyse global monetary supply since the major trend changes in inflation rates are, in most cases, global is around 6% to 7%; within the range of the growth of global nominal GDP, and the acceleration that has been evident since mid-2011 provides further reasons why we should not assume deflation in the western world. Ordinarily, changes in monetary supplies precede inflation by about two to three years this argues for speedy stabilization of inflation rates. Ultimately, in comparing the current situation in Europe and the US with the situation in Japan at that time, which suffered from deflation for about 25 years following the bursting of the bubble at the beginning of the 1990s, there are some very crucial differences that in our view clearly argue against a repeat of the Japan scenario and thus against a deflation scenario. Firstly, the western central banks reacted swiftly and resolutely following the bursting of the bubble in Interest rates were quickly lowered the interest level at the short end of the interest curve has for years been negatively adjusted for inflation and liquidity was made available on a large scale. In contrast, in Japan the central bank reacted with years of delay following the bursting of the bubble. In addition, the corporate and household debt level in the developed world today is significantly lower than in Japan two decades ago. This means that the deleveraging process should also be completed significantly more quickly. And finally, in most industrialized countries, the real estate sector, which was the actual cause of the great recession of past years, is not only stabilizing but also significantly recovering in some cases. 12

13 Update I/2014 Ordinarily, changes in monetary supplies precede inflation by about two to three years this argues for speedy stabilization of inflation rates. 13

14 OUTLOOK 03 THE CASE AGAINST DEFLATION: DEVELOPED MARKETS TODAY ARE NOT LIKE JAPAN TWO DECADES AGO Quick response by central banks negative real yields Real returns for 2 years term 3% 2% Japan 1% 0% 1% 2% Germany 3% USA Recovery in house prices good for banks (2008/1992 = 100) Indexed Japan House prices, indexed 2006 = Japan: land prices Germany Euro area UK Spain: House prices per square metre Ireland: House prices: new houses USA Private sector leverage much lower in US and Europe 220% 200% Japan 180% USA EMU 160% 140% Source : Datastream, Allianz GI Economics & Strategy, data as of January 2014 Legend: US and European series starting in 09/2008. Japanese series starting in 09/1992 (year of first recession post burst of bubble), pushed forward by 16 years 14

15 Update I/2014 Taking all the arguments into consideration, we come to the conclusion that while it is possible that the disinflation trend may extend into the next few months, inflation rates should stabilize in both the United States and Europe over the coming quarters. This is an important support for the recovery of the banking sector, since the need for write-offs in loan portfolios is reduced. In contrast, in Japan real estate prices fell over a period of around 20 years, and thus crippled lending. (Chart 3) Taking all the arguments into consideration, we come to the conclusion that while it is possible that the disinflation trend may extend into the next few months, inflation rates should stabilize in both the United States and Europe over the coming quarters. We are explicitly assuming that both the US and Europe will be able to avoid a deflationary scenario such as the one in Japan. In the long term (that is over the next three to five years) a crucial factor will be whether the western central banks again normalize their monetary policy, or whether they as we expect remain expansive for too long. This means: we will not soon be saying goodbye to the low interest environment, but the risk profile for bonds will continue to be asymmetric in view of the inflation outlook. Stefan Hofrichter As Head of the AllianzGl Global Economics & Strategy team since 2011, Stefan s research covers global economics as well as global and European asset allocation. Stefan joined the firm in 1996 as an equity portfolio manager, and assumed his current role as an economist and strategist in Between 2004 and 2010 he additionally had responsibility for various retail and institutional mandates, including global and European classic balanced funds, global multi-asset absolute return and multi-manager alpha-porting funds. Stefan became a member of the firm s Global Policy Council in 2004, and is a member of the Pan-European Tactical Multi Asset Investment Committee, which was established in He chaired the German Asset Allocation Committee between 2010 and Stefan holds a Diplom degree in economics from the University of Konstanz (1995) and in business administration from the University of Applied Sciences of the Deutsche Bundesbank, Hachenburg (1991). Stefan became a CFA Charterholder in

16 Strategy Best Styles: Harvesting Risk Premium in Equity Investing Harvesting risk premiums is a common investment strategy in fixed income or foreign exchange investing. In equity investing it is still rather new, but well-rewarded. 16

17 Update I/

18 STRATEGY AUTHOR: DR KLAUS TELOEKEN For institutional investors, harvesting risk premiums is a common investment strategy. In asset classes like fixed income or currencies, it is straightforward for investors to think of investing in terms of harvesting risk premiums like the term premium or the credit premium in fixed income, or the carry premium in FX (foreign exchange) trading. Fixed income investors extend the duration of portfolios to capture the term premium in fixed income, or add to corporates and high yields to earn the credit premium. FX investors exploit the FX carry premium by going long in highyielding currencies, and shorting low-yielding currencies. In all these examples, investors take extra risks (duration risk, credit risk, currency risk) and expect to be compensated for this extra risk by means of an extra return the risk premium. Implicitly, the performance of equity managers is to a large extent explained by their exposures to a few equity risk premiums anyway and this is true irrespective of whether the manager is aware of this investment style exposure or not. (Chart 1) As the performance decomposition based on Mercer s GIMD database shows, there can be no doubt that investment style risk premiums are the true drivers of active equity returns. Index providers have reacted, and have recently launched a whole series of indices that target these risk premiums under a variety of different labels like smart beta indices, alternative beta indices or risk premium indices. As we are proponents of the idea of harvesting risk premiums, we think these indices are a good start. For equity investors, however, thinking in terms of equity risk premiums is still rather new. But risk premiums also exist here. Examples include the value premium, the small cap premium or the momentum premium. Value stocks, e.g. stocks with a low price/book-ratio, are usually more risky, as value stocks are typically less profitable, more leveraged and more cyclical than other stocks. The existence of all these risk premiums is well documented in the academic literature. For instance, Basu (1977) 1 discovered that stock with a low Price/Earnings ratio led stocks with a higher Price/ Earnings ratio on the NYSE. Banz (1981) 2 described the size effect small cap stocks outperform large cap names. Titman (1993) 3 found the momentum anomaly stocks that led the market over the last six to twelve months have a tendency to continue to lead markets. The existence of these risk premiums is documented for all major investment regions, and over extended time spans. And, based on our experience, there are not too many patterns in investing that are as persistent as these risk premiums. Therefore, it does make sense to explicitly build a portfolio around the idea of harvesting these equity risk premiums. UNDERSTAND. ACT. Harvesting risk premiums is a proven successful investment strategy across asset classes This concept is also well-rewarded in equity markets Index providers have started to offer a variety of risk premium strategies under labels like smart beta, alternative beta or risk premium indices These smart beta indices are an easy-to-grasp index methodology, but in our view they fail to efficiently earn the risk premiums of investment styles in a stable way AllianzGI Best Styles is a distinctive active equity management approach to harvest investment style risk premiums in a stable way across time Best Styles implements a diversified mix of long-term investment style winners, manages risk factors within investment styles, and also uses bottom-up alpha sources The Best Styles products have outperformed in 13 out of 15 years since inception, largely independent from the economic or the market cycle. 1 Basu, S. (1977) Investment Performance of Common Stocks in Relation to their Price- Earnings Ratios, Journal of Finance 2 Rolf W. Banz (1981), The Relationship Between Market Value and Return of Common Stocks, Journal of Financial Economics 3 Jegadeesh, N. and Titman (1993), Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, Journal of Finance But we think investors can do better when it comes to harvesting individual risk premiums than just buying individual smart beta indices. Typical smart beta indices are not designed to harvest the equity risk premiums in the most efficient way for a client portfolio, but are more designed as an easy-to-grasp index methodology. 18

19 Update I/ WHERE DOES OUTPERFORMANCE COME FROM? EMPIRICAL EVIDENCE Active return decomposition of global equity managers ( ) RESIDUAL 2.5% 2.0% VALUE Active Returns MOMENTUM 1.5% 1.0% REVISIONS 0.5% GROWTH / SIZE / QUALITY RISK 0% Source: AllianzGI, 31 July 2013 For example, simple value indices like the Research Affiliates Fundamental Indices (RAFI) or the MSCI value weighted indices are biased towards companies in financial disarray, but the value premium can be earned more efficiently by avoiding these companies. Minimum volatility indices like the MSCI minimum volatility index, while targeting the low volatility premium, leave the exposure to other risk premiums like value or momentum largely unmanaged, which can result in adverse exposures to these risk factors. These examples demonstrate that, while smart beta investing is a good starting point, investors can do better in terms of capturing individual risk premiums like value or low volatility. And investors can also do better in terms of capturing multiple risk premiums than just buying a multiple of smart beta indices. The reason is that just buying a multiple of smart beta indices often leads to insufficient diversification. However, diversification across multiple risk premiums is warranted. Many risk factors like value or momentum have been very successful over the longer term, but have also experienced significant short-term drawdowns. For example, the value investor had to endure a sharp decline in the run-up to the TMT bubble, or as the financial crisis unfolded in Similarly, the momentum investor suffered from a painful setback after the burst of the TMT bubble, or during the market recovery in A diversified blend of the value and momentum investment styles has earned the risk premiums attached to these investment styles in a much more stable way than each of the individual investment styles. (Chart 2) 19

20 STRATEGY 02 INVESTMENT STYLE DIVERSIFICATION IS KEY TO STABLE OUTPERFORMANCE Relative performance of investment styles for a global universe 120% 100% Diversified Style Mix Value 80% 60% 40% 20% Momentum Source: AllianzGI, February 2014 Historic simulation Dec 1989 Dec 2012: quarterly rebalancing, performance after (estimated) transaction costs. Assumptions of the backtest: since no comparable fund existed in the period under consideration, assumptions were made in order to illustrate past performance as realistically as possible.the model portfolios use a similar breadth of investment opportunities as existing global funds. The performance figures are before taxes and after transactions costs of 50bps, dividends are reinvested. The model portfolio comprises approx. 300 stocks, all overweights in the portfolio are of equal size, underweights relative to the benchmark are restricted to 1%. No constraints are in place with respect to sector or country deviations from the benchmark. The strategy is rebalanced semi-annually, on average 50% half turn portfolio changes p.a. The relative performance of the strategy is shown relative to a global investment universe that represents the liquid investment opportunities over time. The performance of this investment universe may differ from the performance of a benchmark like the MSCI World index. Unless otherwise noted, performance results and valuation presented are in US Dollars. Diversification is key The chart underpins the fact that harvesting risk premiums diversification across multiple risk factors has been key to stable outperformance. But investors can do better in terms of diversification across multiple risk factors than just buying a multiple of smart beta indices. Typical smart beta indices have varying exposures to risk factors to the targeted risk factors, and also to non-targeted risk factors where exposures are unmanaged. This makes correlations between smart beta indices rather unstable, and hence renders an efficient diversification impossible. For example, the correlation between the MSCI risk premium indices for value and momentum shifts over time. Most of the time, like today, the correlation of relative returns is negative, hence there is a substantial diversification advantage from blending value with momentum. However, in prolonged cyclical value rallies like the one from 2003 to 2007, value and momentum typically go hand in hand, and hence there is no diversification advantage left from blending value with momentum. But diversification was badly needed at the end of the value rally in 2008, as both value and momentum stocks tanked as the global economy grinded to a halt after the Lehman collapse. However, for investors in these two MSCI risk premium indices there was nothing that could be done to restore diversification; investors just had to accept the loss of diversification. Smart beta indices like the MSCI risk premium indices are simply not designed with a view to a diversified combination with other smart beta indices, but are designed as stand-alone products. A portfolio manager in an integrated portfolio solution, though, can provide the proper diversification across multiple risk premiums by structuring the individual risk premium portfolios with a view towards the subsequent diversification across multiple risk premiums. To do so, the portfolio manager should manage the composition of the individual risk premium portfolios in a way that allows stable mutual correlations, and hence effective diversification. For example, if the correlations between value and momentum are becoming too high the portfolio manager will: put more weight on those value stocks that are not also momentum stocks put more weight on those valuation criteria that will have a lower correlation with momentum factors to effectively restore diversification between value and momentum. 20

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