What a world we live in. Never in the history of financial markets have the four major developed market currencies – Dollar, Euro, Pound Sterling, and the Yen – delivered a “risk free” rate as close to zero. While this is an explicit problem for an aging developed market world craving income, it is an implicit problem for total return given the low “carry” component in fixed income assets such as core fixed income.
Moreover, in an effort to stimulate growth and inflation expectations, major Central Banks embarked on unprecedented balance sheet expansion known as “Quantitative Easing”. While this produced asset price inflation in the U.S. with the S&P 500 up over 300% since March 9th, 2009 through the end of February 2019, it acted more as a steroid than a medicine as core inflation is still running below the Fed’s 2% target with marginal wage inflation.
A downshift in long-term return expectations
Where does this lead us now? Each year our team publishes “Long Term Capital Market Assumptions” which are 10-15 year annualized return assumptions for major global asset classes. Our 2019 long term capital market assumption for a static 60% U.S. Equity (S&P 500) and a 40% Fixed Income (Barclays Aggregate Index) asset allocation is now down to 5.5% annualized. This is a direct reflection of a quicker than expected run up in equity prices as well as anticipation of a continued low growth and rate environment. To put our 5.5% annualized number into context, this same static 60/40 allocation has delivered a whopping 12.2% return since March 2009 and is over 200bps lower on an annualized basis from our assumptions ten years ago.
Stock-bond frontiers: 2019 vs. 2018 and 2008 assumptions (USD)
Source: J.P. Morgan Asset Management; estimates as of September 2017 and September 2018. *EM: Emerging Markets; DM: Developed Markets
This lower return environment may be a sobering new world for investors, but we believe there are important levers that investors can pull to confront the static 60/40 return challenge.
- Be flexible. Investors can stay reasonably within their risk profile, and be able to introduce dynamic asset allocation to an existing allocation to add or remove asset classes from their portfolio. Given the aforementioned return challenges going forward, investors should be willing to introduce tactical asset allocation to capture market dislocations within equities, fixed income, and alternative asset classes. We believe asset allocation flexibility can improve total and risk adjusted return and how we manage downside risk/total portfolio volatility through our asset allocation choices. A good example is how successful managers have navigated in and out of emerging markets over the past few years.
- Do homework on your managers. If index performance is going to be challenging, manager due diligence is a crucial component to finding ways to outperform the index – or find alpha. We look for long tenured managers that have a proven track record over multiple business cycles and environments. Because a manager’s style is favor for a short time period does not make them a good manager. Good managers should be able to generate alpha over various parts of the business cycle – early, mid or late.
- Prudent Use of Leverage. Leverage is not a dirty word. Leverage can be used to manage risk or to generate return. Exchange traded futures or options on indices such as the S&P 500 or the Eurostoxx 50 are efficient ways to add and remove beta or risk from your portfolio depending on your tactical asset allocation views. In many asset classes, it is more economical to use futures to tactically trade risk versus bearing the transaction costs of buying and selling individual stocks/bonds. Another example is the way interest rate risk and equity exposure can be managed with the use of Treasury futures that can quickly add or remove duration.
- Private Markets. Investors should be open to introducing private asset classes to their asset allocation as expected returns remain attractive to those for public markets. We believe there could be increasing alpha opportunities as disruption in the global digital economy is ripe for the private market industry. Although our cap weighted private equity forecast is roughly 300bps greater than public equity markets, manager selection is critical in this space.
To conclude, while the 60/40 static asset allocation has outperformed investor expectations coming out of the financial crisis driven by an unprecedented liquidity environment, there are reasons to believe that some of those returns have been borrowed from future returns. In this new challenging environment we would encourage investors to be open to flexible tactical asset allocation, have a process for determining consistent manager alpha potential, introduce leverage to make their cash work harder, and finally be able to allocate to private markets if possible.