By Michael Feser
The trade-off between investment return and volatility has undergone a nuanced but meaningful shift. The scales are tipping in favour of investors willing to take incrementally more risk, as the gap between returns on relatively safer asset classes and riskier ones widens.
For the past 20 years we’ve been making capital markets estimates, anchored in lasting secular trends impacting economic performance and focused on predicting long-term equilibrium levels for 50 asset classes and strategies. These have stood the test of time: Our predictions from 2004 closely resembled the actual investment experience of a balanced investor since then to the end of 2014.
On the face of it, the changes we foresee in 2016 are relatively modest. We’re calling for a continuation of meek inflation and subdued long-term growth in the face of what are increasingly divergent cyclical forces across economies globally. Real economic growth in developed markets should average 1.75% over the next decade, down slightly from last year on the back of ongoing demographics trends and narrower output gaps. Whereas developed markets appear to finally emerging from a multi-year deleveraging cycle that has depressed growth, emerging market economies are transitioning from a credit boom into their own deleveraging cycle. These contrasting dynamics imply considerable growth desynchronisation in the next several years, suggesting in turn that central bank monetary policy in major developed markets will also be more divergent than at any time in the last 20 years.
Against this backdrop, return expectations for a balanced investor have actually edged slightly higher, interrupting what had been a multi-year downwards trend of sagging economic projections weighing on the expected market returns. Despite the marginal improvement this year, one could still say that 6% remains the new 8% (we’re calling for 6% average returns for balanced investors over the 10 to 15 year time horizon).
In fixed income, cash returns will struggle to exceed the rate of inflation in light of continued accommodative central bank policy and lower equilibrium real yields, whilst longer-duration U.S. Treasury investors will need a lot of patience to earn just a small premium over cash. The findings are even more sobering, when looking at the return projections for government debt investment in the U.K. and the euro area. Against this dim outlook, high yield should stand out as a comparatively bright spot. Meanwhile, value is appearing gradually in emerging markets debt as economies rebalance, arresting the downward slippage in credit fundamentals.
In global equities, the developed markets return outlook remains disappointing at 6.75% in local currency terms, constrained by relatively low earnings growth and elevated valuations. The picture is slightly better for US equities, on the back of less challenging valuations and somewhat lower margins. Still, buyback activity is likely to continue to mask subdued earnings growth as companies return cash to shareholders to prop up return on equity.
The outlier equity market is Japan, which defies projections. Future returns will depend significantly on the success of corporate governance reform, the landing of the third arrow of Abenomics.
Emerging market equities are increasingly difficult to group together, given growing regional differentiation, but the average return prospects for the 8 largest countries have ticked up to 9.75% in local currency terms. This reflects higher top line revenue growth and valuations that are now moderately attractive in aggregate.
In alternatives, public market return expectations drive approximately 70% of the private equity return and as much as 90% for certain hedge fund strategies such as equity long/short. That said we also assume that rising cross-asset dispersions and higher volatility will play into the hands of hedge fund managers and raised our expectations accordingly.
Manager selection remains a key skill requirement, as investors only fully benefit from investing in alternatives with above median performing managers. We also see marginally more attractive future returns for value-added real estate and infrastructure.
Zooming back out to the overall picture, the salient point here is that, while the overall return environment is broadly unchanged, the balance between risk and return – it’s subtly shifting. Return expectations for riskier assets are improving as return expectations for ‘safe’ assets are deteriorating. Investors with the stomach for volatility can capture these by reducing their exposure to interest rate sensitive assets and increasing their exposure to equity and credit assets.
Michael Feser is a portfolio manager at JP Morgan Asset Management
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