Q: At the start of each year, we would like to begin with a discussion of your outlook across all global asset classes. As you look across the broad opportunity set, what are your return expectations and where are you finding opportunities for attractive return?
Robert Arnott: Past is not prologue. As investors, we want to buy low and sell high, which is easy to say and very hard to do. Whatever is cheap became cheap by treating us badly; whatever is overvalued, and poised to perform badly, got there by treating us very well. This is why successful investing requires that we regularly inflict pain on ourselves. George Soros famously said, “successful investing is very painful.”
There’s a famous Wall Street adage, “never mistake a bull market for genius, or a bear market for stupidity.” Past performance fools us twice. Great performance feels wonderful, even as a stock, a sector or an asset class is getting repriced for much lower future returns. Lousy performance inflicts pain, even as a stock, sector or asset class is getting cheap and is priced to deliver superior returns.
It’s a natural human tendency to forecast the future by extrapolating the recent past. This is the reason people chase performance, which is, in turn, the root source of the most grievous errors in investing. Russ Kinnel, in his seminal 2005 white paper, “Mind the Gap,” found that the average investor forfeits 2.8% per annum by trend chasing, buying what’s hot and selling what’s not.
Money was pouring into the All Asset suite in late 2012 and early 2013, when a bull market in “third pillar” assets meant that even the third pillar was fully priced. Now, after a grinding three-year bear market in our core asset classes – which tends to make those asset classes cheaper, and potentially positions them for terrific current yield and strong long-term future performance – we see meaningful outflows. It’s sad to see our own contratrading against markets cancelled by client trend-following.
This is why – after a three-year bear market in “third pillar” assets, a period of unusually intense pain – my confidence in the future performance of our strategies grows. We do our clients a grave disservice by flinching, as so many investors do, and abandoning our discipline, our process, and our principles in the face of a daunting three-year bear market in our core asset classes. Our clients may flinch, but we will not. We will increase allocations to whatever has become very cheap.
We believe there is value in objectively measuring asset class return expectations. As with most managers, we have no clairvoyant ability to pick tops and bottoms with precision. But, we can forecast long-term returns with surprising efficacy. Anyone can! We fully recognize that our expectations are imperfect and that we have no crystal ball for the future. As Yogi Berra famously remarked, “It’s tough to make predictions, especially about the future.” We evaluate long-term return expectations – not for the purpose of anticipating short-term price movements – but rather for assessing comparative valuation levels across a panoply of global markets and gauging when they are most at odds with market perception.
Our assessment of forward-looking returns is an essential component of the All Asset strategies. Our models give us an objective reason to buy assets after they’ve cratered, when nobody wants to own them, and to sell assets that have lofted to new highs and are basking in popularity. Ironically, the more uncomfortable a trade is, the more confidence we can have that it’s likely to be profitable in the intermediate term, rather than just long-term. This approach goes directly against human nature and is one of the elements required for successful, long-term contrarian investing, which I have practiced for over three decades.
The choice of model for measuring asset class returns is important.1 We chose to use an intuitive framework, based on an assessment of the “building blocks” of long-term return: the current yield, an assumed long-term growth rate of an income stream, and a presumption that valuation multiples, yields and spreads “mean-revert” towards historical norms eventually. All three are provably highly correlated with future long-term returns.
Let’s now turn to our asset class forecasts.2
We believe that U.S. equities are in the late innings of a Fedfueled bubble. Why late innings? Consider the narrowing of the bull market,3 a hallmark of mature bull markets, and the end of Fed stimulus. Although reported earnings in the S&P 500, declined 14.4% in the twelve months ending Q3 of 2015, stocks continued higher, eking out a total return of 2.8% in 2015. Although this gain is modest, it exceeds the returns for almost all other markets, leading to what some have called the worst year for asset allocation in over 75 years.
A casual glance at Figure 1 shows that U.S. equities are priced to a provide a scant 1% real return per annum, net of inflation, compounded for the coming 10 years. How do we arrive at this? Firstly, low yields beget low future returns. The dividend yield of the S&P 500 is 2.1%, which is almost bottom decile since 1871. Secondly, with “New Neutral” demographic headwinds, we believe real earnings growth to be a meager 1.3%, not much different than its long-term average, but much less than the 3.6% growth of the last quarter century.4 Finally, like it or not, valuations matter. Today, on almost any valuation metric, U.S. stocks are expensive, relative to both their history and other asset classes. For instance, the U.S. finished the year at a Shiller price-to-earnings valuation metric of 26x, which is within the top decile of all observations since 1881, while many other markets are far cheaper.
Outside of the U.S., prospective stock market returns look to be much better. For non-US developed markets, our long-term real return expectation is 5%. And emerging market equities? They have had a grinding five year bear market, and now boast an expected real return of 8%, the highest of all major asset classes in our opportunity set! Current yield plus prospective real growth, alone, would deliver a real return of nearly 5% per year. Any mean reversion in the valuation multiples, or in their now-cheap currencies, would boost that further. EM stocks are trading at a CAPE5 of 10.6x; this is well under the lows in the Global Financial Crisis and is well into the bottom decile of the last 25 years.
A soaring U.S. dollar also has a bearing: just as the strong dollar contributed to a slump in U.S. earnings, it can permit earnings to soar in our trade counterparties, notably EM. Better still, PIMCO’s RAE Fundamental Plus and Low Volatility strategies, which is where we mainly invest, now trade at CAPE ratios between 8x to 8.5x! If we can buy half of the world’s GDP for eight times earnings, my goodness, why wouldn’t we? Is this the sixth or ninth inning of the EM bear market? No one knows. But, the early stages of a bull market can be explosive.
Let’s begin with mainstream bonds (the “second pillar”). Like U.S. equities, U.S. bonds are currently priced to offer meager forward-looking real returns, hovering near 1% per annum over the next ten years. Given demographic trends, including fast-aging populations and a natural soaring in support ratios, low yields – even negative real yields for the most secure government debt – seem natural.
While TIPS would likely benefit from both the demographic demand from retiring baby boomers and impending inflation risk, the yields of this overcrowded asset class are just slightly positive, leading to a long-term expected real return forecast that is a tad above 1%. Given our real return focus, we always seek inflation protection, but prefer to attain that through other Third Pillar asset classes, which offer a higher correlation than TIPS all while providing the potential for far better real yields, even after adjusting for default risk.
Finally, we favor emerging market debt – a stealth inflation fighter – which enjoys high current yields and should benefit from 1) capital gains reaped from falling real yields and 2) a boost from productivity gains, fueled by the strong dollar. The past few years have also been characterized by steady upgrades in the credit ratings for many EM countries. Our return expectations range from 3.5% for emerging market non-local debt and up to 5.5% for emerging market local bonds. It’s little wonder these Third Pillar asset classes represent a meaningful exposure in the All Asset strategies!
Credit and Alternatives
With low global real yields, it’s more important than ever to look for opportunities where credit quality is higher than what is priced into yields. It’s important to not just have the courage to find these diamonds in the rough, but to invest when yields continue to blow out. We favor these asset classes, because like their Third Pillar peers, they offer the potential for improved returns in the face of rising inflation.
Bank loans are a perfect example of this. Bank loans have continued to yield upwards of 6% (nominal) while other asset yields have fallen, due less to credit risk of the borrowers and more to stricter lending requirements by the banks. Fear of a run on defaults in the energy markets have driven B-rate high yield spreads to 7%, more than double what they were just 18 months ago.
Our expected real return for Real Estate Investment Trusts (REITs) is less interesting, at 2.2% for the next 10 years, buoyed by a larger dividend yield than the rest of the U.S. equity market. While earnings dilution will always be a problem with an asset class forced to distribute earnings as dividends, in an inflationary environment, from a valuation perspective, REITS are expected to trade like other real assets and not depreciate in the same way as other stocks. For now, we maintain a modest position in REITS.
Commodities, another stalwart Third Pillar asset class, has crashed, due to overcapacity, fantastic weather and slowing global demand, exacerbated by contango (premium prices) in the forward markets, so every contract roll costs us performance, not unlike Sisyphus pushing the boulder up the hill. The oversupply in the oil markets has been reported for over a year now and is expected to continue in the foreseeable future. Fantastic weather has been wonderful for crop yields and outdoor enthusiasts, but dreadful for crop growers and natural gas providers. And finally slowing global demand, especially in China, has hurt the base metals. We believe commodities are being priced based on a steady drumbeat of bad news across all commodity markets. Big opportunities in commodities may be beyond the next cycle, smaller wins will occur with even a hint of good news.
The last three years has been a perfect storm for value investors and for “third pillar” investors. Value has severely lagged growth, as the “FANGs”6 and their ilk soar to the stratosphere, and assets with an attractive yield or valuation multiple have been savaged. We’ve seen this movie before. We know what happens in the next scene, even if we don’t know when that scene will start.