LTCMA Mark-to-Market: COVID-19 – New cycle, new starting point
- Prompted by the profound shock to the economy and markets of COVID-19, we are for the very first time providing an off-cycle mark-to-market of our Long-Term Capital Market Assumptions return projections.
- We have not altered the assumptions themselves but, rather, focused on how the sharp swings in asset prices will affect the long-term outlook for returns and, by extension, portfolio construction.
- While the full implications of today’s policy actions are still vague, the effect of massive fiscal and monetary stimulus, and the associated jump in government borrowing, could eventually lead to steeper curves, a shift in equity market leadership and a tilt in how economic rewards are shared in the years to come.
- We finish with personal recollections and insights gained through previous crises from a dozen of our most senior portfolio managers, strategists and research analysts. While no two bear markets are the same, the lessons of history can offer a helpful perspective.
LTCMA COVID-19 Update: Overview
For the first time in nearly a quarter-century of producing our Long-Term Capital Market Assumptions (LTCMAs), we have elected to provide an update outside of our normal annual publication cycle to the return expectations for a range of asset classes. To be clear, this is not a complete reassessment of our underlying assumptions, and we look forward to publishing our 25th annual edition in November. However, the severity of market moves in early 2020, as well as our memories and experiences of prior crises and recessions, motivated us to mark our assumptions to market.1
The economic optimism that had begun to emerge in late 2019 as the ravages of the U.S.-China trade spat receded, now seems little more than a distant memory. But if we cast our minds back, the world economy was in the latter stages of a record-breaking expansion phase and a remarkable bull market. Nevertheless, a combination of easy policy and a lack of corporate exuberance provided the ingredients for the already aged cycle to extend further. From a long-term perspective, forward-looking asset returns had been pushed inexorably downward as valuations had risen and – as a result of exceptionally easy monetary policy – interest rates had steadily fallen.
Few, if any, outside of the medical and scientific communities might have predicted what happened next. Under the shadow of a burgeoning medical crisis, governments globally faced the trade-off between public health and economic health. Unsurprisingly, public health prevailed, but the price was a sudden stop to the last economic cycle and a rewrite of the economic policy textbook as we knew it.
In this update to our return expectations (Exhibit 1), we focus primarily on taking into account the wild market moves that occurred over March 2020 as global equities swung from bull market to bear market territory in record time. Clearly, however, the market volatility has continued, as the sharp bounce in stock prices through April suggests. As the precise mark-to-market remains a moving target, we have also sought to provide some insight into how sensitive the long-term return forecasts might be to the entry price.
We have also considered the portfolio context and the possible impact that recent policy actions might have on the economic and investing landscape in years to come. Finally, we have asked a dozen of our most senior and experienced portfolio managers, strategists and research analysts to share some of their personal experiences from past crises, ranging from the crash of ’87 to the eurozone sovereign debt crisis. While no two shocks or recessions are the same, we hope that this montage will provide some useful perspective as we navigate the current crisis.
Global government bond returns are down slightly since our last publication, while global equity returns are higher
EXHIBIT 1: CHANGE OF EXPECTED RETURNS FROM 9/30/19 TO 3/31/20 FOR SELECTED ASSETS
Change in expected returns for selected assets
In providing this mark-to-market of our return expectations, we should first note that we have not altered any of the equilibrium economic assumptions or normalization pathways that we published in November 2019. Our economic framework is based on a supply-side model that provides an estimate of trend growth for countries and regions. While COVID-19 is clearly having a deep impact on economic activity today, we see few first-order impacts on the long-term potential growth of the economy. Simply put, we don’t see the coronavirus-linked recession as significantly changing potential growth in the long term. Certainly, some of the policy measures being rolled out today could have an impact at the margin, and we will assess these in our 25th edition of the LTCMAs, due in November, but for the purposes of this re-mark exercise we are keeping our ultimate equilibrium growth, inflation and policy rates unchanged.
As stock markets slumped in March, sovereign bond yields fell and credit spreads widened, translating to a drop in expected returns of 30 basis points (bps) for world government bonds2 and a jump of 170bps for U.S. high yield bonds when we mark-to-market off of March 31 asset prices. But as we delve deeper, we find some interesting nuances. The decline in government bond returns is profound for U.S. Treasuries – with expected returns for U.S. 10-year notes falling 70bps and for the long Treasuries index falling 130bps. By contrast, expected returns for euro government bonds are actually 30bps better, reflecting the extraordinarily low yields already in place well before the start of the coronavirus crisis (Exhibit 2).
Across geographies, the returns on longer-duration bonds are worse than those for cash
EXHIBIT 2: KEY BOND EXPECTED RETURNS (USD, EUR, JPY, GBP) AND FORECAST INFLATION
Key expected bond returns and forecast inflation
Expected returns in credit have improved more or less in inverse proportion to credit quality. This reflects both the level of spread widening that took place and the shorter duration of speculative grade bonds compared with investment grade. The March 31 mark-to-market doesn’t account for the Fed’s recent decision to buy corporate bonds, including some BB rated bonds, which has compressed spreads quickly in April. Equally, however, it does not reflect either the recent oil price volatility or the extended leverage in some sectors – both of which may act to increase credit losses in the near term. On balance, expected returns in credit have risen, and in some cases they approach those available in equity markets. Meanwhile, government bond returns have fallen and in most instances are now negative in real terms. Although duration is set to remain in demand while the world is in recession, today’s buyers of bonds really shouldn’t be looking to hang onto them for the long haul.
Expected returns for stocks have risen across the board by between 100bps and 250bps. This may seem counterintuitive given recent commentary on the risks to earnings, dividends and buybacks. But even though short-term fluctuations in earnings are important, within our LTCMA equity framework we focus on trend earnings, which are linked to long-term potential growth. At the same time, we would not expect restrictions on cash return to persist for long after the crisis and recession start to clear. Although in certain regions and sectors there is near-term pressure to reduce payouts, we don’t expect that to become a lasting theme since the nature of this shock was not a result of corporate misbehavior.
At this stage we don’t expect the current recession to significantly affect potential growth in the long run largely because the losses have been socialized – taken on to the governments’ balance sheet. The medium-term implications for household and corporate financial health should be limited and as a result trend earnings and margins remain largely stable in our outlook. Thus the major change to our forecasts is linked to valuations, and therefore to prevailing prices.
U.S. large cap stocks were long the most expensive of equities, yet throughout the last expansion they set the pace globally due to the high quality of the market and the tilt toward technology. As of March 31, expected returns for U.S. large caps had risen from 5.60% to 7.20%, reflecting the sharp drop in the index over March. While this puts expected returns from U.S. equities much closer to what we consider their fair “secular” level,3 expected returns for other regions now stand well ahead of the U.S. In local currency terms, returns on euro area equities increase 240bps to 8.20%, emerging market (EM) equities increase 90bps to 9.60%, and Japanese equities increase 100bps to 6.50%. Given the current overvaluation of the U.S. dollar, the currency effect further amplifies the expected return premium for non-U.S. markets. But when this is put into risk-adjusted terms, the non-U.S. return premium is lessened (Exhibit 3).
Equity returns have moved higher, driven by better starting valuations. This has implications for Sharpe ratios as well.
EXHIBIT 3: SHARPE RATIOS FOR KEY EQUITY CLASSES, MID-YEAR UPDATE VS 2020 LTCMAS
A rise in expected returns for private equity and real assets
For financial alternatives – notably private equity and hedge funds – the most important driver of returns is the expected return on public asset markets. Higher expected returns across public equity markets translate to an increase in expected returns for cap-weighted private equity of 100bps to 9.80%. Our alpha projections continue to be relatively aggressive for both hedge funds and private equity and recent market volatility actually reinforces our conviction that there is a good medium- term outlook for alpha generation. Notably, dry powder on private equity balance sheets can be deployed now at lower entry multiples, broadly offsetting higher debt funding costs, and higher volatility plus greater dispersion augurs well for hedge fund alpha trends.
Within commodities the plunge in energy prices raises the expected return outlook despite there being no change to our underlying trend growth assumptions. For gold, meanwhile, we have left our return expectations unchanged despite the strong rally in the metal. Over the long run we expect our projection of a weaker dollar and an eventual rebound in inflation to support expected returns for gold.
Expected returns for private real assets have also risen, in our view, but we caveat this statement knowing that the actual marks-to-market are typically possible only six to eight weeks after quarter end. As a result, our estimates based on a theoretical March 31 mark-to-market necessarily have a wide confidence band. We think as a base case that capital values for real assets may be marked down as much as 10% as a result of the prevailing crisis. However, unlike the global financial crisis, when inflated asset values drove impairments, we see much of the markdown arising from the recession-induced near-term hit to cash flows. In the fullness of time, we expect these cash flows to rebound – first in the more stable core sectors, such as logistics, and rather later in more cyclical sectors like hotels.
This translates to an increase in expected returns of between 70bps and 100bps for real estate, and around 70bps for infrastructure, which is generally less cyclical and has greater cash flow protection; REIT returns increase meaningfully due to higher leverage and valuation adjustments.
With expected returns from bonds now impaired due to low starting yields, real assets with reliable noncyclical cash flows are likely to receive renewed attention from asset allocators. As investors move on from the liquidity fears that led to market turmoil in March, it is worth noting that it was real asset innovators that emerged as winners in the post-2008 period. Those assets exposed to technology and to renewables fared especially well, and while we think these themes remain strongly in play for the next cycle, there is an added dimension of fiscal stimulus. Sectors that benefit from this fiscal largesse also stand to be among the winners in the next cycle.
What secular themes might characterize the next cycle?
Across all asset classes, we make only one alteration in this mark-to-market exercise – the starting price. Given that price action, particularly in equity and credit markets, remains highly volatile, we would note that the mark-to-market based on prices from March 31 serves mainly as a guide. Over the coming months, the likely character of the next cycle and the implications of recent policy innovations will become clearer. But one point from this exercise is very clear and is borne out by examining the expected returns based on different starting asset prices (Exhibit 4): The more prices fall in the short run, the greater the boost to long-term expected returns. Put another way, the more bearish one is today, the more bullish one should be about long-run returns.
Entry points are an important driver of long-term returns, especially when markets are as volatile as they have been recently
EXHIBIT 4: LONG-TERM RETURN SENSITIVITY TO ENTRY POINT FOR U.S. EQUITY AND U.S. 10-YEAR NOTE
On the face of it, this may seem an odd statement to make, but it reflects an important observation, which is that we should not confuse cyclical and secular drivers of returns. As we learned in the global financial crisis, treating even profound cyclical issues – banking stability, for example – as a secular drag on returns can lead to an underestimate of long-term returns. Policymakers could, and did, find ways to help asset market returns recover. At the core of our LTCMA framework are our underlying economic building blocks of population, productivity and policy. And while we will have to account for some policy shifts in the longer run – particularly how successfully fiscal stimulus is deployed, and how it is ultimately paid for – the other building blocks of our framework are quite stable. As a result, while starting points matter greatly to our return outlook, we urge readers not to mistake today’s cyclical issues for secular headwinds.
Moving beyond the immediate impact of the price volatility on our return expectations, there are some secular themes that we believe might come to characterize the next cycle. First, we believe that fiscal stimulus will be a game changer. In our 2020 edition of the LTCMAs, we wrote about the failure of monetary policy, noting that in the next recession fiscal stimulus would also be required. Our main surprise is that this has happened so quickly and so decisively. While the current recession will naturally see concurrent disinflationary pressure and low bond yields, we believe more expansionary fiscal policy will be a permanent feature as we emerge from the recession despite the fact that governments will have accumulated significant amounts of debt. There is simply no appetite for new wave of austerity. As a result, we expect both monetary and fiscal policy to remain expansionary into the recovery (a stark difference from the post-global financial crisis period). This in turn should lead eventually to steeper curves and reflationary pressure in the intermediate term.
This is likely to be highly supportive for equities relative to bonds over the full extent of our 10- to 15-year forecast horizon – something hinted at if we look at the extreme levels that equity risk premia have now reached in all major markets (Exhibit 5). Nevertheless, steeper curves and more scope for a reflationary cycle in the next expansion could prompt a shift in equity leadership. Value stocks never quite had their moment over the last 10 years as low yields and a very low inflation backdrop favored longer-duration equity and growth as a style. From a regional perspective, this played to the strengths of the U.S. market – and with the surge in technology it meant that the 2010s really was “the American decade” for stock market returns. The technology theme is here to stay, but with scope for steeper curves, reflation – and the possibility of fiscal stimulus sharply boosting investment in renewables and sustainability – the 2020s might see other regions start to play catch-up.
The recent decline in bond yields has pushed equity risk premia to near historical highs
EXHIBIT 5: EQUITY RISK PREMIA FOR KEY EQUITY MARKETS
The start of a new cycle
The past few weeks will go down in history as one of the sharpest upheavals of economic policy and asset markets ever witnessed. It will also come to be seen as the end of the longest economic expansion on record and – critically – the start of a new cycle. That cycle will have its own unique characteristics, and we expect to be writing on themes such as technology, sustainability, share of economic returns between capital and labor, reflation and style rotation as the new cycle starts to take shape. Still, some of the issues we can see today are immutable: Stock returns are profoundly above bond returns; the simple 60/40 stock-bond allocation is changing, with cash flows from alternatives and real assets increasingly a substitute for coupon income; and diversi- fication remains of paramount importance (Exhibits 6A and 6B).
We believe that the economy will, in time, bounce back strongly from this recession. And while we do not yet fully know what will define the next cycle, we remain convinced that investment opportunities will present themselves as the new economic themes and priorities become clear.
Since our last update, the stock-bond frontier has steepened markedly
1In this exercise, we have simply updated the starting price of assets from that on September 30, 2019, to the prevailing price on March 31, 2020. This captures the sharp market moves of March 2020 but at this time does not update any underlying assumptions – including equilibrium yields and normalization paths for rates and equilibrium valuations and margins for stocks. These will be updated and in the next full edition of LTCMAs due in November 2020. The full details of the current assumptions are available in the 2020 Long-Term Capital Market Assumptions. The mark-to-market exercise has been conducted for expected returns in USD-, EUR- and GBP-denominated assets; it does not extend to updating covariance assumptions, which already include an adjustment for periods of high volatility.
2Global government bonds, hedged in USD.
3Secular return expectations were referenced in both the 2019 and 2020 LTCMA notes and refer to the anticipated level of returns from an asset at equilibrium; in the case of equities, this eliminates the effect of valuation and margins from the estimate.
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