Investments goes in cycles. Each era is distinguished by different sets of characteristics. A defining moment of the present period is a shift to a low-return environment. After solid gains over the past 5-10 years, most assets are at historically high valuation levels implying, on a forward-looking basis, sub-par investment returns. But, what does that mean for long-horizon asset owners? Are draconian changes to investment policy and asset allocation warranted or is it merely managing stakeholder’s expectations that is justified?
Past returns are not a guarantee for future returns – quite the opposite
The past forty years have generated very high returns for bond portfolios. A global portfolio of developed market sovereign bonds has yielded an impressive six per cent a year in real terms. A similar allocation to listed equity has returned a bit more, but it is a photo finish.
We know that those stellar returns for a quarter century was paralleled, or rather driven, by global disinflation. From the early 1980’s to the mid-2000’s, inflation in the OECD-area fell from around 14 % to 2 %. Further declines in bond yields over the past decade was not reflecting still lower inflation rates, however. Since 2005, core inflation in developed countries has been remarkably stable around 2 %, the level most central banks, explicitly or implicitly, are targeting.
Long-term Bond yields, Inflation and CB Reserves
The renewed drop in global bond yields since 2008 is best understood against the back-drop of assertive monetary stimulus with extremely low, or even negative, short-term rates and aggressive central bank bond buying programs. In total, the FED, ECB and BoJ have, between themselves, expanded their balance sheets from around 3 Trillion USD ten years ago to some 13 Trillion today.
“The future ain’t what it used to be”
Bond yields are presently not at an equilibrium, or “natural” to borrow a Wicksellian term, level. Most long-term growth-projections are indeed lower than historical growth rates. In that sense, “the future ain’t what it used to be” as Yogi Berra once quipped.
In a long-term growth projection, the other year OECD, for instance, concluded that 2 % real GDP-growth per annum for the member countries over the coming few decades was a reasonable expectation. Assuming, admittedly rather boldly, that central banks succeed in keeping investors’ inflation expectations around their target over the long-run, that would imply an equilibrium long term nominal government bond yield of some 4 %, clearly below historical levels.
It is inherently difficult to time the pattern of future higher interest rates. Conventional wisdom suggests yields, this time, will rise later and slower rather than quicker and sooner. Whichever, broad based portfolios of developed market sovereign bonds will likely generate very low, if not negative, returns over the coming few years.
Risk Premiums to harvest still
Core business for most long-term asset owners is to harvest systematic risk premiums in various asset classes and segments of asset markets. Investment policy and asset allocation decisions should thus be based on an assessment of the size of such risk premiums. From an investment policy perspective, thus, it is important to distinguish between low return expectations due to low interest rates, on the one hand, and low risk premiums on the other.
Most forward looking risk premiums, today, are at similar or lower levels compared to realized returns historically. But, market pricing suggest that risky investments will nevertheless be compensated with higher prospective returns compared to sovereign bonds.
The term premium i.e. the yield difference between longer-term government bonds and shorter-term government bills, is not conspicuously compressed. In the U.S., the difference is around 120 bps (10 years minus 3 months), which is around 50 bps lower than the average for the past 35 years.
IG Corporte Bond yield vs. Sovereign Bond Yield
A broad-based developed market portfolio of corporate bonds with investment grade status yields around 130 bps more than a matching portfolio of government bonds. This is lower than two years ago and much lower than during the GFC but in line with the average for the past ten years plus. Based on a longer US data-window, corporate bond spreads are now a bit higher than the average for the past century.
EM Bond yield vs. DM Bond yields
Emerging market sovereign debt is also offering a significant premium over developed sovereign debt. The spreads are not as lofty as they were two years ago, but reasonably attractive when compared over a ten-year period, at least were Hard Currency debt is concerned. Hard currency and local indices are priced with a yield some 300-400 bps above a global portfolio of developed sovereign debt.
Prospective Equity Risk Premium
A broad-based portfolio of Developed market equity is priced for sub-historical returns. Clearly, stocks are not as attractive as amid the GFC in early 2009 or at the peak of the Euro-crisis in the summer of 2012. Prospective risk premiums are also lower than realized long-term excess stock returns. However, they still offer a reasonable risk premium at around 300-400 bps. This is in stark contrast to early 2000 and mid-2007 when prospective risk premiums were at minus 2 % and 0,5 % respectively.
Earnings yield gap
A similar metric for Emerging market equity is encouraging, as well. On a relative basis, EM equity is priced with a premium of some 2 % to DM equity. This is roughly the same level as a decade ago and since then EM equity has returned about 2 % a year in excess return over DM equity.
Expectations management is key
When interest rates start to move up more decisively, risky assets could come under duress. But that should first and foremost be a transitionary phenomenon. Investors that are not overly sanguine about their ability to time different phases in the cycle, should stick to a policy portfolio with a distinct tilt to risky assets.
Return expectations must be managed carefully, however. Stakeholders must be aware, and reminded, that a portfolio with a traditional risk profile will return significantly less over the coming five to ten years than most of us are predisposed to believe.