Recent returns of U.S. equities have many investors questioning the usefulness of their long-term forecasts, but that doesn’t mean they should necessarily abandon them. Institutional Investor recently convened a discussion on the strengths and challenges of 10-year return forecasts, including a focus on building a capital market forecast in today’s environment, asking what the risks are, and what it all means for investors and their portfolios. A trio of multi-asset experts representing Aberdeen Standard Investments were at the table: Craig Mackenzie, Senior Investment Strategist; Tam McVie, Investment Director and Absolute Return Investment Specialist; and, Stuart Peskin, Investment Director and Multi-Asset Investment Specialist.
Q: Going back to say, 2015, many investors have missed out on strong equity returns that followed pessimistic equity forecasts. Why did so many forecasts get it wrong?
Mackenzie: The equilibrium for interest rates is set by the global supply of savings and how that matches demand for savings in capital investment, in infrastructure investment, and in business investment around the world. Interest rates went down and down and down throughout the developed world in the last 20-plus years because the balance between the supply of savings and the demand of savings shifted decisively. We’ve been in a perpetual savings glut in the last decade, with far too much savings in the world. That depressed the equilibrium level of interest rates.
Policy interest rates move up and down through the cycle as the Fed tightens and eases, but for long-term bonds a far bigger factor is this equilibrium real interest rates factor. That’s what’s keeping interest rates low today. And we think interest rates are going to stay relatively low. Clearly, we’re in the upswing cyclically, particularly for policy rates, but we don’t see the 10-year bond moving very far above current levels. There might be some volatility, but essentially, we’re in a low interest rate regime that is likely to persist.
What does this all mean for investment strategy? If we’re correct that equilibrium interest rates are going to remain structurally very depressed, we’re going to get low bond returns for some time to come, certainly compared to history. We forecast the U.S. index at something like 2.5% return per annum over the next five years, compared to the last 20 years where you would have seen 6% per annum. A 60/40 equity-bond portfolio works really well when you’ve got a 6% bond return, but it’s disappointing if you’re going to get 2.5% for your bonds. Over the last few years we’ve been thinking very hard about how we can replace bonds as the core diversifiers for our equity exposure. We’ve ended up with quite a different kind of portfolio. What is exciting to us is more attractive returns for less well-known asset classes like floating rate loans, alternative risk premia, smart beta, and asset-backed securities (ABS). ABS got a very bad reputation during the financial crisis when subprime mortgages blew up. But surprisingly most kinds of ABS – corporate loan obligations, European mortgage-backed securities, consumer ABS – did well during the crisis, with few defaults. We also like emerging market debt, which offers much higher yield for only modestly more risk. You wouldn’t want to use EM debt as your sole diversifier, but it can play a part. Overall, we’re thinking much more creatively about how you can run a diversified portfolio without having to accept extremely low bond returns.
Q: Certainly, you’re doing a lot more than just coming up with a central case in your forecast. You’re incorporating downside cases and upside cases, too. What could go wrong in the real world and economic world that could throw off some of the calculations?
McVie: Trade wars are front of mind just now, but ultimately there’s multiple different environments that you could imagine, including a central bank making a very significant policy error. From the thought we devote to considering different potential risks, we create a number of scenarios that we think are currently of interest, and ultimately, on a forward-looking basis, we try to consider what the world might look like.
We need to think about risks within a slightly shorter-term timeframe than that in which we consider returns. How do you start to protect your portfolio? How do you start to think about building a portfolio in the context of this low interest rate regime? The starting point is historical stress tests based on particular moments of stress that have already happened. That’s a useful exercise because it highlights what your portfolio looks like in an environment where correlations are stressed, but you do it knowing full well that it’s not going to exactly repeat itself. That’s why we focus on forward-thinking scenario analysis around extreme but economically plausible outcomes that might disrupt your portfolio.
We recognize that there are limitations to forward-looking scenarios, but we’ve had a couple of instances where we’ve been able to tell how well and how strongly our scenario analysis works. Brexit was a shock event that allowed us to see how the portfolio reacted, and in February of this year when the VIX spiked we had another opportunity to check the process and how portfolios have reacted. We’ve got a reasonable degree of confidence in the process – it’s not perfect, but it does highlight this low interest rate regime and the need for asset allocators to go and find something else that will be diversifying for the portfolio. In certain scenarios, owning bonds could be one of the best performing positions in your portfolio, but equally, if we actually turn out to get a different scenario, it could actually be one of the worst performers in your portfolio. From our perspective flexibility is the key thing. Can you construct views that even within bond markets might actually be more diversifying than just owning outright duration – potentially a relative value between one market and another? Potentially the spread between the UK and Germany might look attractive, and it might actually be helpful. Another might be utilizing currencies as a diversifier. The Japanese yen, for example, is generally a very strong diversifier for lots of different portfolios.
In light of what your colleagues have said, Stuart, what insights can you share with investors around constructing or reconstructing their portfolios?
Peskin: As we engage in discussion with clients, we acknowledge that it’s a natural starting point to look at portfolios in comparison to history. If you look at the performance of a portfolio of U.S. stocks and bonds since World War II and focus on how a diversification of 60% stocks and 40% bonds has done, outcomes look pretty good except for the 1970s, a period of high inflation. But we have to remember that the extremes in interest rates and inflation then became a tailwind for everything that followed for the balance of post-WWII history. The benefit to bonds was straightforward – lower interest rates delivered a positive price return to bonds and lower inflation compressed the inflation premium that was priced in. On the equity side, we observed a ratcheting upwards of objective measurements for mean valuations, which provided a boost to equity returns. So, when we’re thinking about evaluating a diversified portfolio, a traditional 60/40 benchmark is probably not the best idea. I’m confident in saying that because in our forecasts for the next 10 years in terms of return, and looking at the portfolio including upside and downside cases, we’re creating 10,000 outcomes. This creates a meaningful picture of what the outcome might be from a probability standpoint for 60/40 using global equity and U.S. bonds.
In the course of this work, we were able to tease out some very important points about what the outcome is likely to be, and it’s very different from what we see historically. That is, there’s a pretty high probability that we’ll have a 10% drawdown. It’s not going to take a black swan event to have a drawdown in 60/40. Historically, this was not the case.
So, what do we do about that? We modified a 60/40 portfolio modestly by replacing 20% of it with something else. We tested two different things. We tried a multi-asset strategy that is used as an equity replacement, so it delivers equity-like returns with about two-thirds of the volatility. We also put in an asset class that we find attractive – emerging market local currency – and allocated up to 20% in each case. There was only a 10% improvement in terms of those probabilities that I mentioned before. We shouldn’t be surprised by that given the modest nature of the changes we made. We also opened ourselves up to a number of different alternatives and created a diversified mix. How does that do versus traditional 60/40? Importantly, we see the previously mentioned probabilities of bad outcomes fall in a meaningful way – the tool helps us clarify our forward thinking for diversified portfolios, which at the moment are a bit unappreciated because they haven’t delivered the results that people were expecting.
In short, on a go-forward basis, the argument is much stronger that on a risk-adjusted return basis, investors should actually be moving away from the simple, traditional 60/40 allocation, and toward a more multi-asset and diversified portfolio.
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