What a world we live in. Never have the four major developed-markets currencies — dollar, euro, pound sterling and yen — delivered a rate so close to zero. This explicit problem for an aging developed-markets world craving income is an implicit problem for total return, given the low carry component in fixed-income assets such as core fixed-income.
Whereas quantitative easing produced asset price inflation in the U.S., it acted more as a steroid than as a medicine. Core inflation is still running below the Federal Reserve’s 2 percent target, with very little wage inflation. One of the side effects of steroids is that they take a lot of performance and compress it into a short period of time. That is essentially what has occurred in the U.S. equity market. Healthy returns in 2009 (of 26.5 percent) and in 2013 (32.4 percent) were driven more by liquidity than by robust growth. In other words, we were likely borrowing returns from the future to deliver in the present, which is a consequence of quantitative easing — one the Fed was willing to accept to avoid deep and prolonged risk aversion.
Where does this lead us now? Each year J.P. Morgan Asset Management publishes its Long-Term Capital Market Assumptions, which shows 10–15-year annualized return assumptions for major global asset classes. Our 2016 report, presuming a static 60 percent U.S. equity (Standard & Poor’s 500) and a 40 percent fixed-income (Barclays Aggregate index), anticipates a decrease to 5.7 percent annualized. This is a direct reflection of a quicker than expected run-up in equity prices, as well as anticipation of a continued low-rate environment. To put our 5.7 percent annualized number into context: This same static 60-40 allocation has delivered a whopping 11.9 percent return since March 2009 and has made many investors complacent. Nonetheless, we believe there are important levers that investors can pull to confront the static 60-40 return challenge:
Be flexible. Investors can stay reasonably within their risk profile and be able to introduce dynamic asset allocation to an existing allocation. Also, given the aforementioned return challenges, investors should be willing to introduce tactical asset allocation to capture market dislocations within equities, fixed-income and alternative-asset classes.
Do homework on your managers. If index performance is going to be challenging, manager due diligence is a crucial component of finding ways to outperform the index — or find alpha. We look for long-tenured managers who have a proven track record over multiple business cycles and environments. Good managers should be able to generate alpha over various parts of the business cycle: early, middle or late.
Whenever possible, incorporate illiquidity. Not all clients have the ability to include private markets in their asset allocation. For example, most 1940 Act mutual funds that require daily liquidity rarely include allocation to private markets. If you choose, for example, an allocation to private credit, it can achieve equitylike returns with a creditlike risk profile. This is an important tool for either finding yield in a world starved for income or producing better risk-adjusted total return in your portfolio.
Make prudent use of leverage. Leverage is not a dirty word. Leverage can be used to manage risk or to generate return. Exchange-traded futures on indexes such as the S&P 500 or the Euro Stoxx 50 are efficient ways to add and remove beta or risk from your portfolio, depending on your tactical asset allocation views. These instruments are highly liquid and allow you to gain exposure to markets while only posting cash that is consistent with margin requirements.
Although the 60-40 static asset allocation, driven by an unprecedented liquidity environment, has outperformed investor expectations coming out of the 2008 financial crisis, there are reasons to believe that some of those returns have been borrowed from future returns. We accordingly encourage investors to be open to flexible tactical asset allocation, have a process for determining consistent manager alpha potential, allocate to private markets if possible and, finally, be able to introduce leverage to make their cash work harder.
Phil Camporeale is an asset allocation strategist in J.P. Morgan Asset Management’s multiasset solutions group in New York.
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