The Future for Asset Allocation

In the last decade alone, such a strategy has delivered a 5% p.a. return after inflation, or a cumulative 63% gain in real terms, with volatility around 4%.

Wonderful returns. Much better than anyone expected a decade ago.

These figures refer to a hypothetical index portfolio, rebalanced quarterly. They do not take into account trading costs or management fees for which, in all reality, they need to be adjusted lower. Of course, it is worth pointing out that harvesting such magnificent returns required the investor to stay invested. There are countless reasons why that was difficult – scary events such as the banking crisis, the euro debt crisis, flash crashes, China’s devaluation, elections, Brexit, confusing monetary policy changes and Trump’s trade wars to name a few. The same portfolio delivered four stomach-churning quarterly returns of -10% or less since 1990, and -7.8% as recently as Q4 2018.

It wasn’t easy, in other words. Staying invested was the hardest challenge. Those that have done so have been rewarded, deservedly so.

The Future

Looking ahead, however, the journey looks a lot tougher. The returns investors experience are a function of changes in fundamentals (profits, dividends, defaults, inflation, interest rates) and valuations, which reflect the starting-point yield (or risk premia) investors require to hold the asset at any point in time.

It is difficult to say too much with confidence about fundamentals in the decade ahead. Inflation has been very stable around 2% on average for 30 years and this may reasonably remain the case, but even this is uncertain and it is difficult to say much more. Reasonable arguments can be made why future profits should be faster or slower than historic averages, depending on the region. Interest rates are expected to remain very low, but as recent US experience reminds us, expectations can change quickly over the course of 12 months (figure 3 below shows how expectations for the path of US rates collapsed between December 2018 and December 2019).

This leaves us with an observation on starting point of valuations. Real yields on bonds are very low by historic standards and where coupons are fixed, unless a very material deflation arises, real returns from bonds are likely to be very poor over the coming decade, probably negative. Note that the Global Aggregate bond index includes a weighting in credit, where spreads are close to their tightest levels in a decade.

As for equities, they too have seen valuations move higher (yield move lower) in recent years. The earnings yield on the MSCI World is below average, but not as measly as at the start of the century (from which point equity returns were very poor). Equity returns have shown some correlation with starting point yields, but with considerably more variation than bonds. It is reasonable to think that expected returns from equities are lower than they were a decade ago, however.

Altogether, this leaves us with the lowest prospective yield on a 60/40 equity/bond portfolio that we have seen in the past 40 years. That is a sobering thought for future returns.

Of course, if the coming decade brings about a period of stellar profits growth along with lower than expected inflation, real returns from a long-only balanced portfolio may be satisfactory. For such an outcome, it would seem equity markets would have to do the heavy lifting and generate strong returns (and far superior to future bond returns). At current levels of interest rates, along with flat yield curves and compressed credit spreads, bonds simply cannot generate returns anything like their historic average…unless inflation is much lower than expected, which wouldn’t intuitively seem very supportive of corporate profits and equities.

Implications

The implication of the above analysis is that investors should have very modest expectations for future real returns from a simple, passive bond/equity portfolio over the coming decade. Similarly, cash rates remain very negative after inflation, especially outside the US, and most expect them to remain so.

Seeking anything better than low single digit returns is therefore likely to involve taking on much more equity or liquidity risk, or will require a much more active approach. We have made this argument before most notably in the period after the ‘pivotal moment’ in the middle of 2016, when bond yields were at similar slows. Since then we have seen an environment when bonds have been weak (in the immediate aftermath of that phase) and in which almost all assets delivered negative returns (2018). Last year saw a retracement in this trend, causing some to once again question the value of active asset allocation. Such short term deviations in trend are to be expected, but for anyone with a consideration of prevailing valuations and a reasonable time horizon, we would anticipate dynamism and selection to show their worth once again.