Achieving real returns in a low growth world
Simon Doyle, Head of Multi-Asset and Fixed Income, provides the research to our belief that CPI+5% p.a. over the medium term remains an appropriate and achievable return objective in a low growth world. Click the download button below to access the full paper.
The idea that we have entered a “low return” world is now consensus. The arguments are based on a combination of fundamental macro factors (a low growth world) and extended structural valuations in both equity and debt markets, suggesting significant structural return headwinds.
Achieving solid real returns consistently in this environment will be challenging. That said, we believe CPI+5% pa over the medium term is still an appropriate and achievable return objective. This view is based on several key ideas:
– Structural valuation challenges in asset markets are not uniform nor (in the case of equities), are they extreme (either in absolute terms or by historic standards)
– Markets rarely move in straight lines – especially in challenging conditions it is reasonable to expect asset markets to exhibit considerable cyclical volatility around benign trends
– Active asset allocation (in fact active management generally) will be incredibly important in this environment. Capturing the upside of this cyclical volatility will be crucial, but more crucial will be avoiding the losses on the other side
– Consistent with this, approaches that embed permanently the structural risk of either equities or bonds will likely struggle to deliver consistently. This includes both Balanced Funds with fixed Strategic Asset Allocation’s or Risk Parity approaches that embed duration risk (leverage) into the strategy as the risk around bonds becomes increasingly asymmetric.
Valuations matter more than global growth
The correlation between economic factors and market performance is often overemphasised. Strong economic growth does not necessarily mean strong market performance. Whereas the link between valuations and future returns is significant – particularly over the medium to longer term. This is true for both equity and bond markets.
Research shows a strong relationship between longer run, cycle adjusted PE multiples and subsequent 10 year returns as presented in the following chart for US equities.
Figure 1: US CAPE Ratio and 10 year Real Returns for US equities since 1900.
Source: GFD, Yale, Schroders
There are several points to highlight:
– High CAPE ratios have consistently been followed by structurally low returns
– The current CAPE ratio of around 23x, while high in an historic context, is well below the 45x level seen at the end of the tech boom of the 1990’s, which was subsequently followed by a decade of negative real returns;
– We note there is not the same downward pressure on returns that prevailed at past extremes (like the 1970’s or 1980’s).
Whilst structural valuations are moderately extended in the US and consistent with relatively low (albeit not extremely low) prospective returns, in the UK, Europe and Australia, structural valuations are reasonable and therefore consistent with reasonable longer run rates of return.
The problem with bonds
The situation with respect to bond markets is potentially more difficult with record low bond yields implying low/negative returns from sovereign bonds and for assets priced directly from bond yields. This issue has become particularly more acute, with negative yields prevailing across large swathes of the global sovereign bond market (especially Europe and Japan) with extremely low yields in the residual.
Typically bonds have been held in portfolios to help diversify equity risk. Structurally low yields limit the ability of bonds to perform this function.
Implications for long run returns
The issues outlined above are factored into our long run return forecasts for key asset classes. These are primarily derived from a combination of the broader macro-economic backdrop, combined with an adjustment for long run valuations. As Figure 2 highlights, while we expect modest long returns from equities, they are nonetheless still positive in real terms.
Figure 2: Forecast Long Run Asset Class Returns & Current Expected 3 Year Returns
Source: Schroders as at 30 June 2016
In summary, while the structural valuation backdrop is challenging, it is not uniform, nor in the case of equities as extreme as it has been historically. Australian equities for example, having devalued against the collapse in commodity prices, look reasonable long term value. The situation in bond markets is more problematic given prevailing negative nominal and real yields.
Cyclical volatility is evident in bear markets and are both significant in magnitude and endured for relatively extended periods (3-5 years in some cases). This is important as it highlights that the returns are not linear. This is in contrast to structural bull markets where set and forget (ie. beta alone) will deliver.
The critical question is, can this cyclical volatility be managed and captured? Our approach is effectively to condition the long run structural trend return in assets with shorter run valuation dynamics (in the case of equities we focus on earnings relative to trend and the earnings yield relative to the cash rate). This provides us with a disciplined framework as we attempt to buy when risk is low, and sell when risk is high.
Figure 2 above compares our expected 3 year returns to the expected long term returns. It highlights equity markets could be expected to deliver reasonable returns over the next few years, whereas bond markets and assets that have been driven primarily from the decline in bond yields could be expected to struggle.
There are a number of significant investment implications as a consequence of this environment:
– Which market and when will be crucial.
– Sovereign bond outlook looks poor (at best).
– Assets structurally linked to declining bond yields are at risk - sovereign bonds, infrastructure and REIT’s.
– Remain cautious around structured/alternative betas and complex financial engineering.
– Leverage brings additional risk and may not solve the fundamental problem of low returns.
– Transparency, liquidity and the optionality of cash will be important elements of a successful strategy.
– Flexible asset allocation ranges and active management are required.
We agree with the premise that the global economy has entered a world where growth will be structurally lower than what we have seen, and one in which the ability of policy makers to manage the cycle is constrained by a number of factors.
This environment has implications for asset returns but is not the only driver. Valuations continue to matter in both a structural and cyclical context. To this end we think bonds (and bond proxies) are significantly more challenged than equities. While for equities, valuation challenges are neither uniform nor particularly demanding by historic standards. We expect moderate, but positive structural trend returns from equities.
There is no doubt that achieving CPI+5% consistently against this backdrop will be tough. To do this we expect that we will likely be episodically biased to equities over bonds, need to be active and aggressive in managing asset allocation around these trends and utilise active management at a strategy level to ensure maximum incremental return through alpha generation. While the risk to delivering our return objective consistently is to the downside, avoiding material drawdowns and ensuring exposure on the upswings will be paramount.
You can access the full paper by clicking the download button below
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.