As investors prepare for the last quarter of 2021, I want to touch upon the benefits to seek exposure to a broad set of sources of expected return. Our focus rests on public markets. I was triggered to reflect on this complex equation as our return experience over the past 9 months specifically and over the past 3, 5 and 10-year in general might have obstructed realism across future expected return profiles. A traditional balanced 60%-40% equity, bond portfolio boasts a year-to-date performance around 12%. Such portfolios delivered 8.5% annually over the last 3 years and about 7% annually over the past 5 and 10 years.
It might be fair to state that we borrowed future performance by a large extent. Market participants have been mixing the impact of liquidity enhancing central bank policies with fundamental sources of expected return. Remember the episode before the dot-com bubble in 2001 or the Great Financial Crisis of 2008. I recall that most investors got comfortable with low expected returns. Low expected returns in technology stocks by 2001 as well as in real estate and credit over 2006-2007. In both instances the shock was sobering.
And yet again, over the past decade realized returns have been stellar. Nobody in his own mind would have imagined back in 2011 that DM central banks would persistently apply a potent cocktail of negative or zero interest rate policies alongside aggressive long-term asset purchase programs in government bonds. The main objective was to sustain highly accommodative financial conditions. That goal was reached by depressing the bond or term risk premium.
During times of low expected returns, one notices that the narrative in financial markets is geared towards risk management. These days we conduct a lot more discussions related to risks than discussions related to expected return. Of course, the exercise of estimating expected return is a lot harder than estimating an expected risk profile. For the latter we can rely on historical performance volatility series across asset classes as these got impacted by a series of market, economic or tail risk shocks. The March 2020 market crash provided us with another tail risk, black swan moment that feeds our risk learning curve. Expected returns confront us with an uncertain future and take a lot more effort to estimate properly.
At the basic level, expected return is defined by what you get paid for by owning stocks, bonds, commodities…cryptocurrencies. Secondly expected return can be generated by pursuing specific strategies. Value versus quality-growth or momentum in equity stands out. Carry-based investing across global sovereign or corporate bonds springs to mind. Strategies are developed against benchmarks or as unconstrained. Selecting active managers that consistently outperform passive strategies is complex. Moreover, once detected and selected the biggest enemy of successful managers is obtaining genuine loyalty from investors as market shocks might create uneasiness. Active managers will deviate from the index mean. Often investors lose patience and sell at the worst possible moment. Transparent and active communication lines can avoid such bad decision making. Passive investors believe in the wisdom of crowds. They doubt human excellence can survive in markets and skilled investors can deliver higher risk-adjusted returns. However, often passive and active strategies do co-exist. Third, expected return can be generated by seeking exposure to economic or other risks such as recessions, liquidity risk or shocks to inflation. Interestingly, investors that reacted to future inflation uncertainty at the start of 2021, by increasing their exposure to global inflation linked bonds, are enjoying solid 4%+ returns. Most of the time all these sources of expected return overlap each other. They are also interconnected. Positive expected returns are achieved by taking market risk you get paid for or market beta or by investing with skill obtaining alpha. So, in order to optimize our expected return, we mix exposure to asset classes, strategies and risk factors.
That leaves us with the million-dollar question what is the size of expected returns going forward? We can extrapolate past performances into the future, we can forecast returns based on our individual view of the world ahead neglecting past data or we can use specific measures (future P/E estimates, real bond yields, credit risk premium) in order to forecast future return potential. The first method might be fragile as on your bond investments this should translate in lower policy rate anchors and another drop-in long-term rates that is hard to imagine in a world drowned in negative yielding paper. The second might be outright hard to imagine and coloured by our political wants and needs. We tend to think along the lines that would result in positive outcomes characterised by less inequality, more inclusive growth and innovative technological breakthroughs that allow for a climate friendly transition. Often, reality is a lot less forgiven. Thus, we are left with the third method based on visible market measures. Using today’s measures as our guide we arrive at expected returns across most asset classes that are heavily skewed to the downside.
Measures of 10-year US Treasury term premia fluctuate around zero today. These went into negative territory around 2016, the moment the ECB QE program joined the FED QE efforts. Over the past 60 years (since 1961) the US 10-year term premium averaged around 1.50%. Returning to the mean would drive 10-year US Treasuries towards the 3.00% level. Reaching such a level over the next 5-years would trump market forwards by 75bp. Today, the market sees 10-year US rates at 2.25% over a 5-year horizon. Government bond allocations would require longer healing time in order to recover. Investment grade corporate bonds do not have a strong history in providing for excess returns. Negative migration and fallen angels often eat away excess returns. The sector of choice in fixed income remains BB high yield. It’s a sector that enjoys an attractive risk-return profile in the bond world. Especially when a skilled investment manager is selected. However, its positive correlation of about 50% to equity performance volatility can temporarily impact your portfolio badly.
Historically, annual excess returns of US stocks over Treasuries averaged 3% to 5%. Global excess returns of equity over bonds are lower as EM debt still exhibits attractive expected returns with index yields around 5.5% today. Long-run (real) equity returns equal the sum of dividend yield and the real dividend growth rate at constant multiples (Gordon model). The S&P 500 2022 forward P/E trades at just above 20 today for an average dividend yield around 1.35% (just below 1.45% on the 10-year note). So, going forward we will need to see decent dividend yield growth and/or further multiple expansion in order to pocket a positive historical equity risk premium. Weather it’s possible to reach a 3.00% objective might be a leap of faith too far. With the US 30-year long bond approaching 2.00% again we might observe renewed interest given that future cash flows across equity sectors must be sustained at high margins and under highly supportive economic growth conditions. These might be more difficult to sustain than currently priced by markets. Performing the above exercise for European stocks is even more challenging as we lack correct signalling function ability across our EMU yield curves. Indeed, randomness abound as central banks have made estimating expected returns a complex challenge. It is fair to say that expected returns over the next 10 years will not see a repeat of the 7% investors enjoyed. Adjusting expectations towards half or about 3.5% annually might again be a ‘stellar’ result.
Correctly combining expected sources of return, one better admits, has to do as much with art as it does with science.
