The Risk-Return Matrix - January 2017
The reflation rally leaves valuations stretched.
The second half of 2016 was dominated by a recovery in global growth and an uptick in inflation, a reflationary outcome that was a major turnaround from the deflationary scenarios that dominated earlier in the year. Higher, but still-low, inflation and faster growth provided a sweet spot for equities and a problematic environment for bonds, a trend that was turbocharged after Donald Trump won the US presidential election.
The events on financial markets in 2016 leave the Risk-Return Matrix pointing to low returns for asset classes. While bond yields have risen and bond proxies, especially A-REITs, have slumped, our analysis still judges most asset classes to be expensive. In the context of our investment framework where we assess medium-term (three-year) return expectations against risk measured as a composite of the risk of capital loss and the potential size of that loss, many asset classes appear to offer minimal, if any, prospective returns over the next couple of years.
Prospective equity returns are likely to be low in absolute terms, as all equity markets we cover are expected to generate returns below their long-run averages, but stock returns are still expected to be higher than those likely to be produced by bonds.
Within the equity universe, Australia, on our numbers, offers the highest prospective returns while US equities have a more modest outlook. The strong performance of credit in 2016 has left the risks around credit somewhat asymmetric – not much upside but significant downside should circumstances turn against company debt.
We do not think that the recent underperformance of emerging-market equities has made them cheap enough to justify the risks, despite the fact that emerging-market equities offer one of the highest expected returns in our universe. What this forecast does not capture is the potential downside for emerging markets if anything goes awry.
The Risk Return Matrix
As at 31 December 2016.
The Risk-Return Matrix shows the attractiveness of key Australian and global asset classes. Likely returns over the next three years are judged on an absolute-return perspective. Risk is based on the likelihood of capital loss over the next three years.
To find out more about the Real Return (Managed Fund) (ASX: GROW) including its latest asset allocation, go to: grow.schroders.com.au
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.