Allocation Decisions That May Come Back to Haunt 

Kristina Hooper 

The Upshot 


Piling into core bonds at a time when central banks are putting the squeeze on yields and inflation’s being held in check is likely to hamstring real returns, writes Kristina Hooper.

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Kristina Hooper, CFP®, CAIA, CIMA®, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

The first quarter of 2013 ended with a bang—and some important milestones. The S&P 500 posted a respectable 10.61% gain, including dividends, closing Thursday at a record high and eclipsing its previous closing high set in October 2007. The Dow, which had surpassed its previous high reached in 2007 earlier this month, also finished the quarter strong: its 11.93% gain for the quarter was its best first-quarter performance in 15 years.

Stocks Race Higher

But it’s not just about shattering performance records. We’re now hitting some dividend milestones too. In 2012, companies in the S&P 500 paid out $310.5 billion in dividends—a 10-year high for rolling 12-month periods. From 2007 through 2012, dividends grew 14%, according to Barron’s. Meanwhile, the number of companies in the S&P 500 paying dividends has hit a new 13-year high of 405 or 81% of the index. Additionally, the S&P 500 aggregate payout ratio is finally back up to its 10-year median level with a 30% payout. This is a substantial improvement from the fourth quarter of 2011, when the payout ratio was 27.6%, and the fourth quarter of 2010, when the payout ratio was 26.3%.

Bond Bloat

Despite all of this progress for stocks, the response from investors has been fairly subdued. As we chronicled in The Upshot (“The Great Reversal”) on Feb. 19, while cash is coming off the sidelines, more money is going into bonds than into equities. In the first two months of 2013, $51.2 billion moved into taxable fixed-income mutual funds, $9.6 billion into tax-free bond funds and $34.5 billion into balanced funds. That compares with flows of $21.9 billion into domestic stock funds and $36.5 billion into international stock funds. And in taxable fixed income, a lot more money is going into core as opposed to areas offering higher yields: a considerable $12.98 billion went into intermediate-term fixed income.

Still Betting on Bonds

It’s hard to understand recent allocation decisions given that we’re facing a period of financial repression—whereby artificially low interest rates are making it tougher for investors to achieve positive real returns—and we’re likely to remain in this environment for years to come. While investors clearly recognize the perils of overweighting cash and are reducing their exposure to it, they don’t seem to realize the dangers of overexposure to core fixed income.

Investors need to understand that financial repression is a tool that enables governments to grow their way out of debt primarily by pushing rates lower than GDP growth. When debt-financing costs fall below the pace of economic growth, a country’s debt-to-GDP ratio declines. Add inflation and the erosion of government debt accelerates. But while financial repression eats away at government debt, it also consumes personal savings. Cash is certainly vulnerable in this environment, but so is core fixed income, which is eking out a small positive real return.

Inflated Expectations

This disconnect between the investment environment and investor behavior is even more pronounced if you consider short-term expectations for inflation. The most recent University of Michigan consumer sentiment survey shows that consumers see inflation hitting 3.2% over the next year, well above current core and headline inflation. However, while inflation expectations have risen, they’re not yet impacting investment decisions.

Even without substantial inflation, investors are well advised to have adequate exposure to asset classes that are able to generate positive real returns during financial repression. The possibility of significant inflation some time in the future as a result of the dramatic stimulus we’ve seen over the past few years only underscores the need for asset classes that have historically performed well in inflationary environments. For example, investors should consider commodities, real estate and TIPS. And investors should not overlook dividend-paying stocks, particularly since dividend growth, historically, has far outpaced inflation.

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The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.

A Word About Risk
: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.
The Standard & Poor’s 500 Composite Index (S&P 500) is an unmanaged index that is generally representative of the U.S. stock market.

The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded blue chip stocks, primarily industrials, but including financials and other service-oriented companies. The components, which change from time to time, represent between 15% and 20% of the market value of NYSE stocks.

Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. It is not possible to invest directly in an index.

Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585,, 1-800-926-4456.


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