Getting the most from equity allocationsContributor Patrik Schöwitz
Global diversification and active alpha generation can be antidotes to modest equity returns
Relative to historical norms, the long-term outlook for investment returns across asset classes is not inspiring—a reality driven largely by expectations for only modest global economic growth and generally low (but reasonably stable) inflation. That is the overriding message from J.P. Morgan Asset Management’s 2016 Long-Term Capital Market Assumptions, an internally consistent set of 10- to 15-year return, risk and correlation estimates for over 50 asset classes globally.
A modest outlook for global equity returns
Taking a closer look at equity markets, our return estimate (in local currency terms) for developed market (DM) equities is a disappointing 6.75%, attributable to still elevated valuations and modest expectations for economic and hence, earnings growth rates.
Our estimate for emerging market (EM) equities is 9.75%, reflecting more attractive valuations and stronger growth rates for emerging vs. developed markets. This expected 300bps spread is roughly in line with the average over the last 30 years, but still underwhelming, given that it follows almost five years of EM underperformance.
U.S. dollar (USD)-based investors in EM equities should benefit if the dollar retreats over the long run following its strong appreciation during the course of 2015 (and into 2016)—an assumption reflected in our 10.0% USD-based EM equity return estimate. A reversal of USD strength would mean local currency returns could be converted back to more dollars. Globally divergent monetary policies, however, are likely to add to currency and market volatility in the near term.
Our modest return outlook for global equity markets, together with expectations for globally divergent monetary policies suggest that diversification and less benchmark-constrained portfolio management can be more important than ever in managing risk and closing the gap between the returns investors need and what they can expect from market (i.e., beta) returns alone.
Equities—a differentiated view
Getting the most from equity allocations involves more than strategically allocating between just the broad DM and EM equity categories. In estimating long-term returns for individual developed and emerging equity markets, we consider contributions from revenue growth (and its global composition), profit margins, share buybacks and dilution, valuations and dividends. As seen in Exhibit 1, within and among developed and emerging markets, there are important differences in both the drivers and composition of returns. To pick an example, margins, as they normalize from peak levels, are expected to be a negative for the U.S., while improving margins should be a positive for European and UK returns. To pick another, payouts to shareholders will likely be a more important driver of returns in the U.S. than in most other developed markets, and will generally be a less important driver in emerging markets. Within emerging markets, China and Taiwan, at the cheap end of the spectrum, should see expanding price multiples contribute positively to returns, while at the expensive end, prices relative to earnings should be a strong detractor.