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It Could Be Different This Time

Eric Freedman
CAPTRUST Chief Investment Officer 

In the words of baseball philosopher Yogi Berra: “Predictions are hard, especially about the future.” While Yogi’s statement is no doubt true, we find it is helpful and informative to periodically revisit and, if necessary, update our asset class return, risk, and correlation assumptions, taking into account current capital-market and macroeconomic conditions. While publishing asset class forecasts to two decimal places implies a degree of precision that is nearly impossible, we feel it is important to give our clients a sense of where we see potential future investment outcomes.

Our assumptions reflect five- to seven-year forward-looking nominal annualized returns, standard deviations, and correlation assumptions for asset classes and investment strategies across the capital market spectrum. We recognize that standard deviation is not the only definition of risk, so we incorporate many other measures into our portfolio-construction thinking.

The current capital market backdrop is unique, with policy makers (especially central banks around the world) potentially following different policy prescriptions in what remains a global economy still impacted by the financial crisis. Factors, such as global interest rates and economic growth, are always important inputs, but contemporary issues in certain areas are unprecedented. The path forward could be quite different than prior market cycles and points in time.

 Our process includes five key steps:

  1. Finding reasonable proxies for the asset classes and investment strategies we want to forecast. Some have investable benchmarks (e.g. the S&P 500 Index as representative of U.S. large-capitalization stocks), while others like private equity are not investable. Finding suitable proxies for uninvestable benchmarks takes extra time. It is critical to have a proxy that allows us to explore and evaluate relevant asset class or investment strategy properties. Index and exchange-traded fund (ETF) proliferation has created numerous proxies to select from.
  1. Understanding historical relationships, valuation methodologies, and the factors (collectively referred to as drivers) that shape asset class returns, movements, and relationships with other asset classes. While past is not necessarily prologue, history provides important context for us as we evaluate what variables matter when assessing an asset class or investment strategy.
  1. Taking a contemporary view of asset class drivers. Recognizing current fundamentals can help shape our forward-looking view on all three aspects of our forecast: returns, standard deviations, and correlations. For example, we look at current valuations, bond spreads, general interest rate levels, and fund formation trends, among other variables.
  1. Assessing potential future outcomes. While it is difficult to look out five to seven years, we consider scenarios that could impact asset class and strategy drivers. This can include weighting probabilities of potential future states or central bank policy regimes.
  1. Comparing our forecasts with research partners, peers, and competitors. Our assumptions are just that: ours. We are fortunate to have myriad resources at our disposal. Those resources are valuable to us in that they serve as a reality check to help us assess where our differences lie. We do not strive to be within the consensus opinion. We are, however, interested in understanding others’ processes so we can refine or validate our own. 

While we do not think that history is a failsafe guide to the future, we believe that mean reversion, or a tendency for short-term processes to revert to long-term averages, is one of the most powerful forces in the universe. Think about the 20-handicap golfer who birdies the first two holes of an 18-hole round; a bogey or two is just around the corner.

Asset classes are no different. Over time, their true underlying properties, or more technically the risk premia they provide investors, emerge. Thus, when market observers use phrases like “it’s different this time,” we typically raise a skeptical eyebrow. Too many are quick to declare a short-term trend to be a new paradigm. In fact, the reason we choose a five- to seven-year forecast timeframe is that this period represents a typical full business cycle. It is long enough to allow asset classes to experience sufficient economic expansion and contraction for them to deliver their total return and portfolio correlation benefits.

Current Backdrop

Recalibration is the word that best captures our current forecast’s cornerstone thesis. Capital markets are forward-discounting mechanisms, with investors and traders buying and selling securities based on today’s view of tomorrow. After the financial crisis, investors became comfortable with a world in which major central banks, especially the U.S. Federal Reserve, actively bought assets in an attempt to restrain borrowing costs and spur consumer demand. The consistent and massive asset purchase programs (totaling over $14.5 trillion between the U.S., China, Europe, and Japan) were both equity- and bond-market friendly.

Their uniform central bank policies have since divided. Seeing some economic momentum, the U.S. Federal Reserve ended its asset purchase plan in late 2014, and it raised its target interest rate in December 2015. However, other parts of the world are not seeing growth materialize, forcing different policy decisions. China’s transition from an infrastructure- and export-oriented economy to one driven by a consumer spending means slower economic growth and reactive policy responses. Japan and Europe are both trying to combat sluggish growth with ongoing stimulus measures.

As the world recalibrates to these new macroeconomic realities, interest rates, a key asset-pricing component, are at historically low levels. In some countries, we currently see negative nominal rates. This phenomenon is truly different from past environments. The primary difference is that investment returns over this business cycle will likely be lower than prior history, when interest rates were a lot higher.

Our central belief over the forecast timeframe is that the current recalibration period will mark a sluggish economic trajectory followed by a gradual recovery. We note that forecasters, such as the U.S. Federal Reserve, International Monetary Fund, and the Organization for Economic Cooperation and Development, all anticipate increasing growth for the U.S. and the rest of the world over the next few years—before slowing to levels below longer-term trends. We are not as optimistic about the shorter term. While we do not formally forecast gross domestic product (GDP), we do assess likely trends. Our analysis suggests there is a greater likelihood that GDP stagnates and then resumes growing. We agree that below-trend growth is the most likely scenario.

Asset Class Returns and Standard Deviations

Figure One below details our new asset class return and risk assumptions alongside our previous thinking. For purposes of brevity, we will provide a cursory overview of our methodology by asset class. Please contact your CAPTRUST representative if you would like additional information on our forecast or the underlying methodology. 

Figure One: Capital Market Forecasts

 

Inflation

Inflationary measures are typically best extrapolated from capital markets. However, we agree with a recent Fed Chair Janet Yellen’s concern that low interest rates and other technical factors may be clouding market-based tools. Using data from the Federal Reserve, Congressional Budget Office (CBO), and a variety of market-based indicators, we come up with an inflation assumption that is slightly higher than current market-based readings (e.g. the Treasury inflation-protected securities market relative to nominal bonds) but lower than the Fed and CBO’s expectations. Our assumptions reflect a trend toward lower economic growth followed by a resumption higher.

Domestic Equities

Our equity market forecasting process adopts both demand-side and supply-side approaches, building on a framework outlined by Dr. Antti Ilmanen and using inputs from the Stern School’s Dr. Aswath Damodaran.[1],[2] Using this approach, we come up with return forecasts slightly higher than our previously published forecasts, but we also increase our standard deviation assumptions to reflect the Fed’s policy shift and volatility associated with the recalibration phenomenon.

International Equities

We are reducing our return expectations for both developed and emerging market equities. For developed markets, while valuation measures are more compelling relative to history, demographics in Japan and Europe coupled with less globally competitive companies warrant a lower valuation. For emerging markets, the commodity market fallout and response to a potentially tightening Federal Reserve dampen our return outlook. Lower expected inflation also hurts both asset classes. Note that, due to a lower absolute forecast, we are reducing our emerging market standard deviation assumption.

Fixed Income

Our cash return assumption is slightly lower than our prior assumption. This is simply a reflection of a slower Federal Reserve interest rate increase path than previously forecast.

For high-quality, longer-duration bonds, prevailing interest rates and yield have historically provided a lot of insight into future total returns. For core fixed income, we are slightly increasing our forecast returns to reflect a slower Fed, but we are increasing our standard deviation assumption to reflect a wider range of potential outcomes for an asset class that has not moved much. Long-duration government bonds have a slightly lower risk than our prior assumptions due to prior outcome overestimation. However, we are raising our standard deviation assumptions for long-duration corporates.

For high yield bonds, we are raising our return expectation due to increases in credit spreads. Recent energy sector disruptions have caused yields to increase to levels above historical averages. While spreads could widen further as energy sector pain continues, we expect current spreads to decrease over a full market cycle.

Alternative Assets

For public real estate, we are slightly increasing our full-cycle returns due to underlying funds from operations growth, but we are penalizing real estate investment trusts (REITs) compared to their long-term averages due to their richer valuations. We are reducing our private real estate forecasts due to uncertainty around underwriting standards.

Commodities have been a much-maligned investment in this most recent business cycle, and we are increasing our return expectation due to the extreme declines across the commodity complex. To be sure, negatives remain, including excess capacity in energy supplies, slowing economic growth, and unfavorable price curves across futures markets. With excess capacity likely to be forced out of the system over a full market cycle likely occurring at an irregular pace, we are increasing our volatility expectation due to a wider range of outcomes.

Private equity is our highest expected-return strategy, and proxies tend to underestimate its true standard deviation. Believing that we are in the latter stages of the private-equity cycle leads us to reduce our expectations as well as our forecast illiquidity premium.

Finally, we see broad hedge fund strategies producing returns that continue to reflect a challenging backdrop. 

Correlations

For correlations, using longer-term relationships can be instructive. However, consistent with our thesis that today’s low interest rates may obscure these relationships, we have increased correlations between fixed income and equities and other riskier asset classes. This phenomenon may persist simply because the shock-absorber function that fixed income has long provided during equity market contagion has diminished as interest rates have fallen.

Click here to view our asset class correlation matrix.

In general, we expect an increase in correlations between riskier asset classes, such as global stocks, high yield bonds, and commodities, during this recalibration period. Lower interest rates play a part here as well. When interest rates decline, investors quest into areas like real estate for yield, driving up values and making asset classes converge to similar risk factors. For example, Chinese growth worries should have a greater portfolio impact on equities than real estate, but if valuations for real estate are high, China suddenly becomes more relevant.

While our new forecasts are not materially different from our prior forecasts, they are materially different from historical experiences. With global interest rates at historically low levels, investors are forced to rethink their return expectations for all asset classes. Coupled with our view that economic growth trends will be lower rather than higher, and that we are unlikely to revert to longer-term potential over this business cycle, we are forecasting a persistently lower return environment. The positive side of this is that the longstanding worry that interest rates will move up quickly and hurt bondholders is unlikely to occur. A lower return environment presents its challenges, but we see a myriad of opportunities within subsets of the asset classes and strategies discussed herein.

Sources:

[1] Ilmanen, Antti. “Expected Returns”. Chichester, United Kingdom: Wiley & Sons, 2013.

[2] “Historical Implied Equity Risk Premiums.” Aswath Damodaran data file site. Accessed January 14, 2016. http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/implpr.html.