Redefining Risk in the Next Phase of Financial Repression

Redeﬁning Risk in the Next Phase of Financial Repression

How to ﬁnd new opportunities and combat new risks in a rising-rate, slow-growth environment

us.allianzgi.com Redefining Risk Introduction to ﬁnancial repression

What is financial Why is it important to repression? redefine risk? A series of government actions (lower interest Even as it shifts to its next phase, financial rates, increased regulations, etc.) designed to repression means a continued environment stimulate an economy and reduce debt while of low yields and slow but steady inflation that maintaining inflation. could last for some time to come. In this world, staying low-risk could mean the big risk of It’s been used before and has been very missing your long-term goals. successful, which is a big reason why— unbeknownst to many investors—financial This flipbook will show you how to redefine repression has been in effect all around the your real risks as you seek to combat financial world for several years now. repression and its related headwinds.

2 A new phase of financial repression Redefining Risk means new headwinds

Phase I Economic Outcomes Investor Headwinds Financial repression ◾ Fed and other central banks pump in massive ◾ Strong investor risk aversion (2007–2013) amounts of liquidity to stave off global economic ◾ “Safest” investments become expensive and yield collapse little income ◾ Highly accommodative central-bank policies cause ◾ Market volatility spikes from time to time interest rates to fall to record lows

Phase II Economic Outcomes Investor Headwinds Financial repression ◾ Fed reduces liquidity, interest rates eventually ◾ Fear of losses (see Headwind 1) (2014 onward) climb (while remaining relatively low) ◾ Fear of missed opportunities (see Headwind 2) ◾ Economic growth improves; inflation becomes more ◾ Continued lack of income (see Headwind 3) likely longer term ◾ On the horizon: ◾ Government deficits decrease, but debt - Inflation (see Headwind 4) remains large - More volatility (see Headwind 5) - Demographic shifts add to debt (see Headwind 6) - Rising interest rates

3 Headwind 1: Renewed risk aversion is keeping some Redefining Risk investors in cash, limiting income potential

In 2007, you needed $2.9 million in cash to generate $100,000 in income. Why This Matters In 2013, you needed $142 million to generate the same amount. If you’re not properly Change in income from 1997 to 2013 allocated to investments Equities 10-Year Treasuries High-Yield Corporate Bonds Convertibles Cash that generate the income potential you need, financial

1997 repression's low yields and persistent inflation could steadily erode your wealth.

2002 Fear of market losses could be limiting your potential for long-term 2007 gains

◾ More than 1 in 4 Americans think cash is the best way to 2013 invest money not needed for more than 10 years1 ◾ High-net-worth investors $0 $5,000,000 $10,000,000 $100,000,000 $150,000,000 allocate 39% of their portfolios to cash on Source: FactSet and US Treasury Department, Bloomberg and Allianz Global Investors, as of 12/31/2013. average2 1. abcnews.com 2. Citi Private Bank Past performance is no guarantee of future results. Equities are represented by the S&P 500, high-yield corporate bonds by the BofA Merrill Lynch HY Master II Index, convertibles by the BofA Merrill Lynch All Convertibles All Qualities Index and cash by the 90-day Treasury bill. Based on yields for the indexes as of 12/31/1997, 12/31/2002, 12/31/2007 and 12/31/2013 obtained 4 from FactSet. Headwind 2: Some investors are afraid Redefining Risk they’ve missed the boat

The long-term run-up in stocks might prompt fears of a correction Why This Matters If you’re afraid opportunity Growth of the S&P 500 since the financial crisis Do you expect a significant correction for US has passed you by, or if you stocks in 2014? fear a significant correction 2,000 6.7% in the markets, you could be at risk of not maintaining adequate long-term exposure 1,500 33.3% to stocks.

1,000

Index (price) 40% 500

0 2008 2009 2010 2011 2012 2013 20%

No, only minor selloffs Yes, 10% or more Yes, a bear-market correction of 20% or more Don’t know/unsure

Source: FactSet as of 12/31/2013 and CNBC Investor Poll as of 12/5/2013. 5 Headwind 3: Traditional income sources Redefining Risk still may not cut it

Even if rates rise, many investments may still generate less income Why This Matters than they did five years ago Financial repression has Income generated from a hypothetical $100,000 investment redefined some notions of risk and reward, causing 12/31/2006 12/31/2013 Projected 75 bps increase in rates a big income shortfall in $6,000 traditionally “safe” asset $5,007 classes and forcing investors $4,790 $5,000 $4,690 to hunt for alternative income sources. $4,000 $3,790 Rising rates won’t change $3,040 $3,000 the need to search for new income streams. $2,000

$1,130 $1,000 $820 $380 $70 $0 3-month T-bill 2-year 10-year Treasury note Treasury note

Source: Bloomberg and FactSet as of 12/31/2013. Past performance is no guarantee of future results. Based on yields for the indices as of 12/31/06 and 3/31/14, obtained from Bloomberg,and FactSet. 6 Headwind 4: “Real-feel inflation” Redefining Risk is eroding purchasing power

Although traditional inflation yardsticks have stayed relatively low, Why This Matters everyday costs have been rising much more quickly than wages The prices we pay for goods Increase in cumulative per person expenditures and earnings (2000–2014) and services—particularly health care and college, two Earnings Expenditures of the biggest expenses for 200 high-net-worth investors— 162% have been trending higher. 150 130% What will happen when inflation spikes—which, 100 historically, has happened 72% 63% suddenly and without 50% 50 41% much warning?

Percentage increase -5% -8% 0

-50 Gasoline Higher Health Electricity Wages Groceries Phone Clothing (and Other Education Insurance (Average Hourly Services Motor Fuels) Services Earnings)

Source: Bureau of Economic Analysis, wages data are from the Labor Department, as of 1/31/2014. 7 Headwind 5: As tapering continues, Redefining Risk volatility may rise

The “fear index” moved lower as the Fed bought more bonds Why This Matters Quantitative easing has Monetary policy vs. the VIX had a calming effect on the stock market. CBOE Market Volatility Index—Index Price Level Federal Reserve balance sheet (left) (right) Tapering—the “winding 60 4.2 down” of the Fed’s bond purchases—is likely to 50 3.6 Trillions of dollars result in greater volatility as stocks transition from being 40 3.0 supported by monetary policy to being supported by Index (price) 30 2.4 fundamentals.

20 1.8

10 1.2 2009 2010 2011 2012 2013

Source: FactSet and Congressional Budget Office, weekly data as of 12/27/2013. 8 Redefining Risk Headwind 6: Demographics are skewing older

Our aging population is adding to our fiscal woes Why This Matters The demographic picture is Number of workers to support Social Security worsening in the US. ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● Entitlement spending has risen from 31% of the federal 1950: 16.5 workers to … 1 beneficiary budget in 1982 to 62% in ● ● ● ● ● 2012—and is projected to grow larger. 2005: 3.3 workers to … 1 beneficiary More retirees and more ● ● ● ● spending will make it harder 2025: 2.3 workers to … 1 beneficiary to grow our way out of debt.

Source: “The 2009 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds” as of 5/12/2009. Past performance is not a guarantee of future results. 9 Why we believe financial repression Redefining Risk is here to stay

The Evidence Our Analysis

Debt levels remain high globally Keeping interest rates low—a key element of financial repression— helps lower debt-servicing costs and reduce debt

The economic recovery is still lackluster In the absence of strong economic growth, governments need to implement financially repressive policies to stimulate their economies

Central banks are the key drivers of global markets With such a long way to go to restore growth and reduce debt, the financially repressive policies that have been driving markets are likely to continue in some form for years

10 Redefining Risk Getting out of debt takes time

As long as the world remains in a debt crisis, financial repression isn’t going away Why This Matters The debt crisis in the Government debt-to-GDP ratios (actual and projected) developed world was years Actual data Japan Greece Italy in the making and is historic Projected United States Spain Emerging markets in scale. 300 For many countries, it will 250 be difficult to lower debt as a percentage of GDP to a 200 sustainable level.

150 It could all add up to many more years of financial

100 repression. Gross debt levels vs. GDP

0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Source: IMF as of October 2013. Forecasts are inherently limited and should not be relied upon as a guarantee of future results. 11 History has shown financial repression Redefining Risk to be an effective tool

Thanks to financial repression, we reduced our post-WWII debt level … Why This Matters but then we ran it back up again After WWII, US debt rose Debt/GDP since 1940 to nearly 122% of GDP—an Actual data unsustainably high level. World War II Projected 140 Financial repression helped lower that number to almost 120 30% by the mid-1970s. 100 Policymakers hope financial 80 repression will work again today—but that means 60 investors must be prepared to 40 deal with its effects. Financial Repression Percentage of gross domestic product 20

0 1940 1950 1960 1970 1980 1990 2000 2010 2018 estimate Source: Congressional Budget Office. For details about the sources of data used for past debt held by the public, see Congressional Budget Office, Historical Data on Federal Debt Held by the Public (July 2010). Notes: The extended baseline generally adheres closely to current law, following CBO’s 10-year baseline budget projections through 2018 and then extending the baseline concept for the rest of the long-term projection period. The long-term projections of debt do not reflect the economic effects of the policies underlying the extended baseline. Data from 1929 onward reflect the recent revisions by the Bureau of Economic Analysis to the estimates of gross domestic product (GDP) in past years and CBO's extrapolation of those revisions to projected future GDP. 12 The Fed will use its tools Redefining Risk to do what must be done

The low rates associated with financial repression have reduced Why This Matters debt-servicing costs, but the overall public debt level is still high Because the US economy Federal interest outlays and debt since 1940 is growing slower than Federal outlays: Interest Net federal debt held by expected, the Fed needs to (left) the public (right) keep rates low. If not, debt- 300,000 12,000 servicing costs will increase, raising debt levels and 250,000 10,000 hurting economic growth

Billions of dollars even more. 200,000 8,000 With limited choices for the 150,000 6,000 Fed, investors need to be realistic about the likelihood Millions of dollars 100,000 4,000 of seeing historically low rates Financial Repression continue. 50,000 2,000

0 0 1940 1950 1960 1970 1980 1990 2000 2010 2013

Source: US Treasury data as of fiscal year ending 9/30/2013. 13 What’s different about financial repression Redefining Risk in the Great Recession?

Financial repression, then and now Why This Matters We’ve lived through financial 1945–1979 2007–Present repression before, but it’s a bit different now. Today, Financial crisis, Great Recession push fiscal policy is less closely discretionary economic policies toward growth Post-WWII policies favored Monetary Policy in a low-inflation period aligned with monetary growth over price stability Stimulative monetary policies suppressing policy, unconventional interest rates reduce Treasury financing costs monetary policy tools are being used more frequently Slow economic recovery, low inflation, and demographics are less Inflation, persistent economic Economy & Debt structurally unbalanced budget raise favorable. growth reduced debt/GDP ratio debt/GDP

“Great Society” began amid Congress deadlocked over budget reform, reluctance to raise taxes in era of Politics debt financing in era of housing-market distress, social unrest, housing expansion, elevated unemployment accelerating inflation

Favorable demographics, Less-favorable demographics, new laws and global industrial leadership Growth Outlook regulations, growing foreign competition point boosted sustained long-term to modest long-term economic growth economic growth

Source: Allianz Global Investors. 14 Take a new look at old risks: Redefining Risk Focus on the financial repression risk zone

Use the “Smart-Risk Spectrum” to assess how financial repression is affecting your portfolio

Alternatives “Moving out on the risk/reward spectrum” has always meant taking Stocks on greater risk to principal in return for greater reward potential. Financial repression hasn’t changed that. Investors with sufficient risk- tolerance levels should consider allocating a portion of their portfolios to risk assets in a time of financial repression.

Bonds Potential Reward

Cash

What has changed are traditional notions of low-risk investing. Financial repression may have put new risks into play.

Financial Potential Risk Repression Risk Zone

Important considerations: Optimal allocations relative to the Smart-Risk Spectrum will vary over time depending on macroeconomic conditions and an individual's investment time horizon, financial status and risk-tolerance level. Investors should consult with a financial advisor when determining an asset allocation suitable for their 15 investment needs. Unlike cash and fixed-income securities, equity securities do not offer a fixed rate of return and entail a greater risk to principal. How to prepare for the next phase Redefining Risk of financial repression

5 ideas to help you move out of the financial repression risk zone (continued on next page)

Investing Idea Investment Opportunity Key Differentiator Diversify bond AllianzGI Short Duration High Seeks superior risk-adjusted performance by investing in short- 1 allocations Income Fund duration, higher-quality high-yield bonds using a unique top-down, A: ASHAX | C: ASHCX | I: ASHIX | P: ASHPX bottom-up approach. AllianzGI High Yield Bond Fund Its seasoned investment team employs a proven process that seeks A: AYBAX | C: AYBCX | I: AYBIX | P: AYBPX to minimize credit risk and target the higher income and growth potential of high-yield bonds.

Explore multi-asset AllianzGI Global Allocation Fund Pursues risk management, long-term growth, income and real 2 solutions A: PALAX | C: PALCX | I: PALLX | P: AGAPX return by investing in a wide spectrum of global asset classes and acutely focusing on risk management. AllianzGI Income and Growth Fund High-yield bonds, convertibles and equities with covered-call A: AZNAX | C: AZNCX | I: AZNIX | P: AIGPX options provides income and growth while helping to moderate downside risk.

Add dividends for AllianzGI NFJ Dividend Value Fund Focuses exclusively on dividend-paying stocks trading at attractive significant income A: PNEAX | C: PNECX | I: NFJEX | P: ADJPX valuations, offering potential for income and capital appreciation. 3 potential

There is no guarantee that any of these strategies will be successful or result in a profit. 16 How to prepare for the next phase Redefining Risk of financial repression

Ideas to help you move out of the financial repression risk zone (continued from previous page) Investing Idea Investment Opportunity Key Differentiator Look beyond the US for AllianzGI NFJ International Value Fund Invests in undervalued, dividend-paying international stocks 4 attractive valuations A: AFJAX | C: AFJCX | I: ANJIX | P: AFVPX and has the ability to invest up to 50% in emerging markets.

Seek organic growth AllianzGI Global Water Fund Accesses a major global growth opportunity by investing in 5 in stocks A: AWTAX | C: AWTCX | I: AWTIX | P: AWTPX companies that provide technologies to improve the supply, efﬁciency or quality of water.

AllianzGI Technology Fund Invests in global companies that use technology to gain A: RAGTX | C: RCGTX | I: DRGTX | P: ARTPX a competitive edge and is managed by two of the longest- tenured technology-fund managers.

There is no guarantee that any of these strategies will be successful or result in a profit. Investors should consider the investment objectives, risks, charges and expenses of any mutual fund carefully before investing. This and other information is contained in the fund’s prospectus or summary prospectus, which may be obtained by contacting your financial advisor. Please read the prospectus carefully before you invest. A Word About Risk: Equities have tended to be volatile, and unlike bonds, do not offer a fixed rate of return. Bond prices will normally decline as interest rates rise. High-yield, or “junk,” bonds have lower credit ratings and involve a greater risk to principal. Convertible securities involve the added risk that securities must be converted before it is optimal. Below-investment-grade convertible and fixed-income securities involve a greater risk to principal than investment-grade securities. Derivative prices depend on the performance of an underlying asset; derivatives carry market, credit and liquidity risk. A security in the value portfolios may not perform as anticipated if the market does not agree with the portfolio manager’s value assessment. Investments in smaller companies may be more volatile and less liquid than investments in larger companies. 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. Investing in a limited number of issuers or sectors may increase risk and volatility. Securities purchased in initial public offerings have no trading history, limited issuer information and increased volatility. Investing in the water-related resource sector may be significantly affected by events relating to international political and economic developments, water conservation, the success of exploration projects, commodity prices and tax and other government regulations. Investments in commodities may be affected by overall market movements, changes in interest rates and other factors such as weather, disease, embargoes and international economic and political developments. Leverage can magnify losses during adverse market conditions. Investing in mortgage- and asset-backed securities involves interest rate, credit, valuation, extension and liquidity risks and the risk that payments on the underlying assets are delayed, prepaid, subordinated or defaulted on. 17 Glossary, chart information and Redefining Risk index definitions

Fed: US Federal Reserve. S&P 500 Index is an unmanaged market index of large capitalization com- QE: Quantitative easing. mon stocks. PCE inflation is inflation measured by the personal consumption expenditures NASDAQ Composite Index is a market-value weighted, technology-oriented price index. index composed of approximately 5,000 domestic and foreign securities. Gross domestic product (GDP) is the value of all final goods and services MSCI All Country World Index (MSCI ACWI) is a free float-adjusted market produced in a specific country. It is the broadest measure of economic activity capitalization weighted index that is designed to measure the equity market and the principal indicator of economic performance. Forecasts and estimates performance of developed and emerging markets. As of May 2010 the MSCI have certain inherent limitations, and are not intended to be relied upon as ACWI consisted of 45 country indices comprising 24 developed and 21 emerg- advice or interpreted as a recommendation. ing market country indices. Consumer price index (CPI) measures changes in the price level of con- The MSCI Emerging Markets Index is a free float-adjusted market capitaliza- sumer goods purchased by households. tion index that is designed to measure equity market performance in the global emerging markets. BofA Merrill Lynch US Treasury Current 10-year Index is a one-security index comprised of the most recently issued 10-year US Treasury note. The Citigroup 3-Month T-Bill Index, an index of three-month Treasury bills. index is rebalanced monthly. In order to qualify for inclusion, a 10-year note BofA Merrill Lynch All Convertibles Index, which measures the perfor- must be auctioned on or before the third business day before the last business mance of US dollar-denominated convertible securities not currently in bank- day of the month. ruptcy with a total market value greater than $50 million at issuance. Barclays US Aggregate Index is composed of securities from the Barclays BofA Merrill Lynch US High Yield Master II Total Return Index, which Government/Credit Bond Index, Mortgage-Backed Securities Index, and tracks the performance of below investment grade (BBB), but not in default, US Asset- Backed Securities Index. It is generally considered to be representative dollar-denominated corporate bonds publicly issued in the domestic market. of the domestic, investment-grade, fixed rate, taxable bond market. CBOE Volatility Index® (VIX®) is a key measure of market expectations of Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 near-term volatility conveyed by S&P 500 stock index option prices. Since its actively traded blue chip stocks, primarily industrials, but including financials introduction in 1993, VIX has been considered by many to be the world’s and other service oriented companies. The components, which change from premier barometer of investor sentiment and market volatility. time to time, represent between 15% and 20% of the market value of NYSE stocks.

18 Redefining Risk Important information

Past performance is no guarantee of future A Word About Risk: Equities have tended to be Derivatives can lose substantially more than the results. This is not an offer or solicitation for the volatile, and unlike bonds do not offer a fixed original amount invested and can also limit purchase or sale of any financial instrument. It is rate of return. Dividend-paying stocks are not upside potential. REITs are subject to risk, such as presented only to provide information on invest- guaranteed to continue to pay dividends. Bond poor performance by the manager, adverse ment strategies and opportunities. The material prices will normally decline as interest rates rise. changes to tax laws or failure to qualify for contains the current opinions of the author, High-yield or “junk” bonds have lower credit tax-free pass-through of income. Treasury which are subject to change without notice. ratings and involve a greater risk to principal. inflation-protected securities (TIPS), issued by Statements concerning financial market trends Convertible securities involve the added risk that the US government, are Treasury securities are based on current market conditions, which securities must be converted before it is optimal. indexed to inflation whose principal value is peri- will fluctuate. References to specific securities Foreign markets may be more volatile, less odically adjusted according to the rate of infla- and issuers are for illustrative purposes only and liquid, less transparent and subject to less over- tion. Repayment upon maturity of the adjusted are not intended to be, and should not be inter- sight, and values may fluctuate with currency principal value of TIPS is guaranteed by the US preted as, recommendations to purchase or sell exchange rates; these risks may be greater in government. TIPS decline in value when real such securities. emerging markets. Investments in commodities interest rates rise. may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments.