Investor briefing Q&A - Multi-asset

 1. What is the impact of global politics on markets?  Please comment on Trump, European elections, Brexit, etc?

When global equities fell 7% in the days following the UK’s European Union (EU) referendum, it appeared that the tone for markets may have been set for the next year ahead. A number of elections in Europe and the US were supposed to have the potential to turn politics - and markets - upside down.

But that was as bad as it got.

While global shares fell 2.9% in the wake of Donald Trump’s surprise win in the US presidential election in November, the stockmarket’s trajectory could not be deflected from its upward path.

Since a post-Brexit low of 6,105.5 on 27 June, the MSCI World Index - a broad measure of global stockmarkets - has risen by nearly 20%. 

Though political noise can hardly be ignored, the key driver of asset market performance will be the broader interaction of valuations with growth, inflation and policy. To this end, while geo-political uncertainty is clearly heightened, global growth remains reasonable with major economies having little near term risk of recession, moderate inflation and central banks still reflecting a cautious and therefore supportive stance of monetary policy.  On the other hand, valuations are clearly stretched suggesting there is little room for error in the event that a geo-political event impacts economic or policy conditions.

2. What will be the effect on markets and interest rates as central banks reverse loose monetary policy and begin to unwind their balance sheets?

Apart from the ‘Taper Tantrum’ in 2014, markets in the US have taken the reversal of loose monetary policy in their stride.  Three rate hikes have been priced in for 2017 together with an expectation that the Fed will begin reducing its balance sheet towards the end of the year. 

The key to an elegant exit to loose monetary policy has been regularly communicating intentions well in advance combined with the appropriate policy mix and sequencing to avoid inadvertent harsher tightening of financial conditions. So far so good in the US but investors will need to be alert to a shifting policy mix, not only in the US, but in Europe and Japan too. 

3. What are your views on macro conditions, e.g.  What are your wage and inflation forecasts and the prospect that the RBA will raise rates?   What are the implications for markets?

Macro conditions, particularly growth and inflation are the 2 things that matter most from an economic perspective.   Growth and inflation are important because they tell us something about corporate profits and the likely direction of policy.

If we take the current US economic situation, then the flow of data suggests decent growth (maybe on trend or above) and moderate but rising inflation. The growth / inflation mix also suggests that while monetary policy may need to edge tighter, it also suggests no inherent rush to take policy to a restrictive stance to materially slow the economy to effectively dampen future inflation. From a cyclical perspective, this is a good environment for equities and the most likely reason why equities are rallying.

In Australia, the RBA recently signalled increased confidence that growth and inflation will continue to recover and that headline inflation should be at the mid-point of the target band by mid-2019, and GDP growth picking up to +3.25% yoy by late next year. With the downside risks to these forecasts easing and risks to financial imbalances increasingly in focus, the RBA's overall outlook looks increasingly inconsistent with rates remaining at emergency record-low levels.

The economic story though is only half the story.  The other half of the story are valuations. There will come a point where the economic story – good, bad or indifferent, is in the price, and more likely, has been over-discounted. Our process compresses these factors into return forecasts which give us some idea as to the returns we can expect from key assets over the next 3 years, based on current valuations – the more stretched the asset, the lower the prospective returns are likely to be.

4. Why are your 3 year return forecasts so low?  eg 2% returns in US equities appears low.

Our forecast methodology has been calibrated to capture both underlying structural trends and cyclical valuations. We compress these factors into a 3 year timeframe and express risk in probability of loss terms – a more meaningful risk metric than volatility. 

Starting valuations matter and in simplest terms when valuations are high, future returns are more likely to be low and vice versa. 

In the current US environment where both valuations are above long term averages and corporate earnings are above trend, we have a double headwind operating against future returns to US equities. 

Our current forecasts for broad asset class returns and risk are shown in Figure 1:

Figure 1: 3 Year Return and Risk Forecasts (As at 30 May 2017)

Source: Schroders as at 31 May 2017. Data shown above is based on Schroders’ estimates. Countries, stocks and sector weightings and returns are mentioned for illustrative purposes only and should not be viewed as a recommendation to buy/sell. Past performance is not an indication of future performance. 

There are several key points to note from Figure 1:

• Overall returns are both relatively low (all less than 8% pa) and relatively compressed (mostly between 2% and 6% pa give or take). They are neither pessimistic nor optimistic but rather (in our view) realistic;
• Projected returns from bonds and bond proxies (like A-REITs) remain low, albeit slightly improved in the case of US and Australian government bonds;
• The key US equity market offers investors limited return in absolute terms and not much different to that offered by US government bonds (where’s the risk premium?).

More “optimistic” forecasts might provide short term but illusory comfort for investors but being as close to reality as possible with our forecasts is much more important. The more realistic the view of what may lie ahead, the better the decisions we’ll make to prepare for it. 

5. Do you also consider size of potential loss when considering probability of loss?

Given our objectives reflect a clear focus on downside risk management, the asymmetry in returns and the size of potential loss is important.

If we replace our 3 year return forecast with the potential downside of each asset class we see a different picture in Figure 2 below. 

Figure 2: Probability of Loss and Potential Downside Loss (As at 30 May 2017)

Source: Schroders as at 31 May 2017. Data shown above is based on Schroders’ estimates. Countries, stocks and sector weightings and returns are mentioned for illustrative purposes only and should not be viewed as a recommendation to buy/sell. Past performance is not an indication of future performance. 

There are several key points to note from Figure 2:

• While EM equities have one of the higher expected returns the potential downside limits the use of this asset class in our fund.   We prefer Australian equities with their higher forecast returns and lower potential downside relative to other risk assets.
• While bonds have a high probability of loss their potential downside is limited relative to equities, however, remain unattractive relative to cash as a defensive asset.
• Property, ie REITs, remain expensive with high probability of loss and downside.   We hold a short position in REITs 

6. Is your Real Return Fund's CPI+5% return target achievable in a low return world?   How will you achieve this target with 32% cash?  What other assets or strategies are you using or not using?  Eg, derivatives, short selling?

Clearly based on current market levels and broader valuations for key assets, simply owning broad market beta in a set and forget approach will likely come up short against our targets.   That said, we are still confident that our objective of 5% p.a. above inflation is a realistic and achievable objective. Achieving it though won’t be easy and will require us to focus on two things:

Firstly we will need to actively manage our market exposures. Starting points matter in the current environment of low expected returns to key assets, static beta exposures will be insufficient. Where, how and when we take risk will be important. We know that returns won’t be linear, meaning that an active and importantly unconstrained approach to asset allocation should be an important part of a strategy to close the shortfall gap implied by current valuations and subsequent returns. Avoiding drawdowns and deploying capital judiciously will be vital.

Secondly, while broad asset class returns look problematic, there are better opportunities at what we’d describe as at a “sub-asset class” level. In this bucket we would put currencies (as they realign to reflect evolving fundamentals and risks), relative value opportunities as broader themes adjust, and in interest rate markets in particular as economic conditions (including inflation) and the policy backdrop realign. We also expect that judicious security selection at the sector level we be important as both a source of return and a risk mitigator.

7. How has the AA positioning of your Real Return strategies changed over the past year?  How well do you think you timed the move out of equities/high yield into cash over the past 12 months?  Why do you have no property exposure?

We have been managing the fluctuations in asset prices relatively aggressively over the last 18 months or so as markets have oscillated between deflation / recession and inflation / growth but all within the context of relatively full valuations. Figure 3 below shows how we’ve bought risk when it was cheap (Sept’15 and Q1’16 and sold it as risk premia narrowed depressing future returns. Our overall exposure to typical growth assets is currently on the low side as we have trimmed risk amid the recent rise in equity prices and narrowing in credit spreads. Cash is elevated but off its highs.

Figure 3 – Actively managing asset allocation

Source: Schroders. Portfolio positions for the Schroders Real return CPI+5% Fund 

We’ve added exposures to emerging market debt (but mainly for currency exposure and diversification), sterling (GBP) as it fell sharply post Brexit and saw a significant improvement in its valuation, and traded in and out of reflation positions in resource stocks and inflation linked bonds. While we have trimmed some of this risk, we remain cautious on bonds and bond proxies like property and continue to reflect this through a short exposure to A-REITs. 

8. Is there a risk that markets are mispriced for longer than they should be?  Is the opportunity cost of waiting for a crash/fall too high?

Valuations always assert themselves in the long run, however, cycle and liquidity are also part of our asset allocation framework for precisely the reason that markets may be mispriced for longer than they should be.  Shorter term cyclical factors, investor sentiment and liquidity indicators can assist in timing the entry and exit of positions.   While our risk objective of minimising the incidence and magnitude of drawdowns will mean we miss out on some of the late cycle momentum, we are confident that we will be more than repaid as we avoid the wash from markets repricing. 

There is no perfect crystal ball and no-one can time markets precisely.  In our experience it is better to be too early than too late and short term underperformance is the price one pays for setting up the portfolio for longer term outperformance 

9. What are your views on the USD, GBP?

We believe that the AUD is moderately expensive relative to the USD and risks are to the downside due to the potential for growth in China to disappoint (impacting commodity prices and the AUD) or interest rate differential between the US and Australia widen further. 

The GBP is extremely cheap relative to fair value and this cheapness was exacerbated by the Brexit vote a year ago.  We added some GBP exposure to our strategies a couple of months ago and have added to this position following the announcement of the snap UK general election to be held in June. 

Source: Datastream, Schroders to 30 April 2017