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Focus on income generation will yield most alpha: McCulley

Institutional investors should be looking to garner alpha from income-generating investments, rather than growth, as the “new normal” dictates that return expectations will be equal to about nominal GDP, according to managing director, Pimco, Paul McCulley.

McCulley said fiduciaries that have made promises on the old normal will have to accept that they won’t be met, as GDP expectations will be in single digits, and this had implications for investment allocations.

“In a world of lower alpha you want to have more coming from income than from a punt on growth”, he said.

However he said there was still a role for growth-generating assets, pointing to emerging markets as a source of growth.

“Emerging market countries are doing a transformation to a more domestic demand-oriented model to lift the prosperity of their people. But in general, with respect to the developed world, portfolios need to be directed towards a focus on income.”

However he said that didn’t have to be just in the form of fixed income, suggesting an equity allocation to solid, dividend-paying stocks would be appropriate as well.

“In the old world, nominal GDP was levered so alpha was greater, then the bubble burst and alpha was negative,” he said. “We have reached the point where we started moving to positive alpha, but that is not the new normal, just an unwinding of Armageddon.”

McCulley, who is responsible for all of Pimco’s short-term cash decisions and interaction with central banks, said the risk of global economic Armageddon had been truncated with force. However that did not translate to a sustained market rally, rather “we are sitting somewhere between heaven and hell”.

“The fear of a modern day depression is no longer, and I credit that to the force of sovereign balance sheets being replaced for the broken and damaged balance sheets of the corporate sector. In the long term want to get back to a more capitalistic system, sovereigns have been a bridge.”

However he said there was a difference between cutting off the fat tail of Armageddon risk and introducing the fat tail of a boom.

“Central bank intervention should and did induce a rally in risk assets which was the unwinding of a possible Armageddon but that is not the same thing as anticipating a boom,” he said. “There is something between hell and heaven and we should price ourselves for prolonged purgatory at least for a couple of years.”

He also said that the concerns that bloated central banks balance sheets would lead to an inflationary problem down the road are vastly overrated.

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