Thursday, March 12, 2009

The Time Is Right for Real Return Investing

By Chris Caltagirone and Bob Greer Long-term investment success depends on taking a thoughtful, dispassionate view of how the economy and financial markets will perform in the future and constructing a broadly diversified portfolio that is structured to take advantage of opportunities that may arise in the future. That is not an easy task amid the current market turmoil, but it is the role of an active manager. PIMCO believes that commodities and Treasury Inflation-Protected Securities (TIPS) are currently two sectors that can provide investors diversification as well as exposure to sectors that may benefit from future economic developments. Despite the price declines seen in both of these markets in the second half of 2008, PIMCO believes that commodities and TIPS are poised to recover in the medium term, when economic growth and inflation begin to increase. TIPS also are likely to offer good value in the near term. Investors can gain exposure to both asset classes through PIMCO’s CommodityRealReturn® Strategy, which combines derivative commodities exposure collateralized by an actively managed TIPS portfolio. In addition to potential outperformance over the medium term, the strategy can offer investors the benefits of investing in commodities, such as diversification, and the benefits of investing in two real return asset classes – this is what PIMCO calls Double Real® return opportunity. Positive Outlook for Commodities Despite the dire scenario in the global economy and markets, the credit crisis and the decline in commodity prices may actually be sowing the seeds of future commodity price appreciation. Due to lower prices and tight credit, commodities producers are delaying projects for capacity expansion, which could constrain future supply when global growth resumes. For example, farmers are likely to cut their plantings because of falling prices for crops and lack of financing to buy fertilizers. The result: reduced supply and the potential for higher prices if demand increases. While the current outlook for commodities is uncertain because it is not clear how long or how severe the global recession will last, we do know that commodities are starting to show less correlation with each other. As each individual commodity begins to be affected by its own supply factors, rather than just expectations for lower demand due to the recession, we are seeing diversification even within the sector. All of this points to potential for a recovery in the commodity markets, which would be a welcome development after last year’s 35% decline in the Dow Jones AIG Commodity Total Return Index, despite gains in the first half of 2008. A number of factors converged to drive commodity prices lower. U.S. drivers clocked fewer miles and switched to more fuel-efficient cars, as the U.S. Strategic Petroleum Reserve discontinued its purchases of West Texas Intermediate crude oil and Nigeria had fewer oil production disruptions; favorable crop conditions created expectations for global wheat surplus; the credit crunch forced investors to exit commodity futures positions, making the market less liquid and exacerbating price movements; and as liquidity problems on Wall Street spilled over to Main Street, expectations for a global recession drove commodity futures prices down further. It’s important to note that despite this barrage of negative factors, the futures markets continued to function properly throughout the credit crisis, which was a true test for all markets. TIPS Attractive Due to Price Decline TIPS, too, declined in the second half of last year, posting a 2.35% decline in 2008 after rising 11.6% amid inflation concerns in 2007, according to the Barclays U.S. TIPS index. Investors fled to the liquidity of nominal Treasuries after the bankruptcy of Lehman Brothers last year, and a fundamental shift in inflation expectations also drove TIPS prices lower. The breakeven inflation rate (the spread between real yields and nominal yields) actually turned negative at times, all the way out to 10-year maturities, suggesting the market was pricing in outright deflation. The decline in TIPS prices makes them attractive now on both an absolute basis and relative to nominal Treasuries. In addition, although we expect inflation to remain low in the near term, we believe that inflation will rise in the medium term, which means TIPS may be a more strategic, as well as tactical, investment opportunity. In the near term, our outlook is for low to no year-over-year headline inflation. We expect several months or quarters of negative consumer price index readings due to excess capacity and production and lower employment levels. Lack of both cost and demand inflationary pressures, combined with below-potential growth, should keep inflation subdued. However, PIMCO believes that the policies of the Federal Reserve and the Obama administration, which are designed to avoid deflation, are likely to reflate the economy over the next three to five years. Breakeven inflation rates currently reflect expectations of nearly 3% deflation over the next five years. This is not PIMCO’s outlook and suggests that TIPS are significantly undervalued relative to nominal Treasuries. Although we expect growth to contract in 2009, government stimulus may reflate the economy as soon as 2010 and beyond that. Combining Commodities and TIPS Given the outlook for higher inflation, PIMCO’s CommodityRealReturn® Strategy may provide a timely investment opportunity. The strategy gains exposure to commodities through derivatives that track the Dow Jones AIG Commodity Total Return Index, and the derivatives are collateralized with an actively managed TIPS portfolio. The combination of commodities and TIPS offers Double Real® return opportunity, designed to capture both commodity inflation through exposure to the index and broad price inflation via the TIPS portfolio. This double exposure to real return is especially attractive in light of our outlook for higher commodity prices and higher inflation over the next three to five years. The CommodityRealReturn® Strategy can offer other benefits. Through commodity exposure, investors gain diversification, which potentially reduces risk in a portfolio. The fundamental factors that drive commodity prices are different than those that drive stock or bond prices. Although the markets can at times rise or fall together – as they did in late 2008 – they often diverge due to the range of different factors that can influence each sector’s prices. Over long periods of time, commodities have historically shown negative return correlations with stocks and bonds. In addition, by using derivatives that track a commodities index, the strategy achieves broad exposure to the asset class without the complication of owning individual commodities. Finally, the CommodityRealReturn® Strategy may add alpha over the long term because it is actively managed. Leveraging our proven investment process, our expertise in managing derivatives and our 35-plus years of experience managing fixed income securities we seek to take advantage of structural inefficiencies and risk premiums in the commodity markets and actively manage the TIPS portfolio in order to potentially provide above-market returns for investors. (Please click here for more on the CommodityRealReturn® Strategy.)

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