My Diary 735 --- The Search for Long-term Asset Returns: Economy

My Diary 735 --- The Search for Long-term Asset Returns: Economy, Bonds, Equities, Currency and Commodities

Tuesday, November 06, 2012

“The search for long-term asset returns” --- The past few years have been very difficult for investors. Unfortunately, the coming future promises to be challenging as well. Economic growth in DMs will be lackluster, while the disinflation tailwind that provided a boost to many asset classes in recent decades has run its course. Low current yields nearly guarantee poor nominal returns on govt bonds in the coming years, which will undermine balanced portfolios and those with liability-driven investment mandates like insurance managers. The global opportunity set offers decent return potential in select assets, but on balance, aggregate portfolio returns will be disappointing by historical standards.

Investors have been hunkered down in recent years, following the deepest recession in 80 years and in light of unprecedented policy measures and profound structural growth headwinds. The search for yield and security has driven bond yields to extraordinarily low levels, and left many investors with bond & cash heavy portfolios that will produce poor future returns. The flip-side is that the 1990s cult of equities has died. Stocks have produced poor returns for more than a decade, while simultaneously suffering sharp losses and substantial volatility. Equities are now a hard sell in secondary markets, but in my view, they are where the long-term relative opportunity lies.

Hurt by the poor returns, many investors have turned to alternative investments in an attempt to improve returns or produce a better risk-reward trade-off. Real estate, private equity, commodities, distressed debt, long-short equity, wine, sports memorabilia and art represent alternative investment approaches that can complement more traditional public market investments. In aggregate, alternative investments can squeeze out alpha by arbitraging market inefficiencies, taking advantage of market illiquidity and allocating capital to more productive investments. However, in the end, returns on alternative investments will also be driven primarily by macro factors including economic growth, inflation and interest rates. There is no free lunch, so while some will generate significant outperformance, most will fall short of expectations. Looking out over the next decade, there are myriad factors that will determine investment returns, most of which are subject to considerable debate.

The objective of this diary piece is to lay out an internally consistent, rigorous framework for projecting returns. I believe this can assist many investors like myself in understanding risk and return, while providing a general road map for the future. Of course, returns for any given year will vary sharply, but hopefully, having a clear longer-term view will make it easier to navigate the cycles. To forecast long-term return, the most common is simply to extrapolate from past trends, i.e. assume that future returns will be similar to those in the past. Alternatively, one can employ a simplified CAPM approach, by estimating the prospective return for the risk-free asset, and then adding a return premium for risk assets such as equities. As a professional investor, my projections are based on macro and asset-market fundamentals, including economic and earnings growth, inflation and policy, anticipated asset-market valuations given the macroeconomic backdrop, and assessments of risk. The below forecasts incorporate elements of reversion to mean, but many future trends will be distinctly different from the past and are crucial in assessing return prospects.

The LT Global Economic Outlook

There is considerable uncertainty about the long-term economic outlook given lingering structural headwinds in many developed countries, large public sector debts/deficits, the unprecedented policy backdrop and persistent global imbalances, among other factors. These structural headwinds do not preclude sustained positive economic growth, but they do imply that the DM economies will grow at a subdued pace by historical standards. EM economies, in contrast, should continue to expand at a rapid pace given their superior fiscal and private sector debt positions, as well as ongoing catch-up to income levels in the developed world. Even so, EM economies will grow at a slower pace in the next ten years than in the past decade.

The above table taken from the latest IMF World Economic Outlook shows the growth, population and inflation forecasts for key economies over the next 10 years. They include the impacts of recessions and recoveries during the period. The key points are --- 1) Real global GDP growth averages 3.1%, well below the rapid (4.5%) pace immediately preceding the 2008-2009 recession, but comparable to the average of the past three decades. In significant measure, the good performance of global growth reflects the growing weight of the faster-growing EM economies. 2) Growth in DM economies averages a tepid 1.5%, modestly below the rate of 2000-2010. This largely reflects slower population growth; real per capita growth is broadly comparable (keep in mind that there were two recessions in the 2000-2010). 3) EM GDP growth averages 5.5% per year (vs. 6.3% from 2000-2010), although it is trending toward 4.8% by the end of the period as the catch-up gains vs. the DM economies diminish. EM GDP per capita (USD) rises from 11% of DM level to 19%. 4) The US would avoid a Japan outcome, but headwinds and muted productivity gains constrain growth to about 2% per year. The EUR area stays together, but lags the US because of slower population growth and weaker productivity gains. Japan continues to fall further behind, as its population declines. 5) China remains the world’s fastest growing large economy, but growth slows to about 5% at the end of the period, reflecting slower population and productivity growth, as incomes rise.

Meanwhile, global inflation remains muted, averaging about 2.5%. Globalization, elevated UNE rate in the next few years, and stronger productivity in EM economies caps wage gains in the DM economies. A gradual “normalization” of monetary policy also prevents inflationary pressures from escalating. EM inflation moderates to an average of 3.5% per year. It is anchored in significant measure by China, where strong productivity gains temper increases in unit labor costs. Interest rates in the DM economies gradually rise and eventually converge with underlying growth trends. However, interest rates will remain low by historical standards because of subdued economic growth and muted inflation. The above forecasts translate into a material change in the structure of the global economy in the coming decade. Emerging markets’ share of global GDP rises from 38% in 2012 to 55% over the period. China becomes the world’s largest economy before the decade is out. Global economic power will continue to move from the DMs to the EMs.

The LT Bond Markets Outlook

The long-term outlook for government bonds is abysmal. Low current nominal yields translate into near zero returns in real terms over the coming decade across most DM markets. Corporate bonds (including HY) produce much better absolute and relative returns, although much lower than in the past decade. EM sovereign debt strongly outperforms DM government bonds. Today’s low government bond yields reflect soft economic growth, super-low policy rates, central bank buying, low inflation, investor risk aversion and debt deflation fears. Based on the 10-year economic outlook, G7 government bonds are massively overvalued, implying poor prospective returns.

Based on current yields and inflation forecasts, and assuming a buy-and-hold basis, prospective nominal returns are broadly equivalent to current yields. However, the forecasts include the impact of re-invested bond coupons, so prospective returns are moderately higher than current yields would imply. The re-investment impact is greater for countries with higher starting yields, such as Australia. Yields are projected to rise materially in the next decade in all major DM markets based on the growth and inflation outlooks. The 10yr USTs is projected to climb to about 4.5% by 2022, consistent with nominal GDP growth and a modest term premium. One important implication is that investors will be able to roll over maturing bonds into higher yielding bonds (hence better prospective returns), but will suffer consistent MTM losses on their aggregate portfolio until yields have broadly normalized, several years down the road.

The outlook for inflation-protected government bonds is even worse than for conventional. This reflects both lower starting real yields and muted projected inflation. The 10yr US TIPs are projected to deliver a marginally negative real return over the next decade, slightly less than the corresponding nominal bond. Fortunately, the outlook for corporate and EM bonds is somewhat better. The expected returns on EM USD and LC sovereign debt with higher starting yields imply better gains from re-investment than government bonds will provide, especially as bond yields in general trend higher. Real returns are highest for US and EUR HY debt, although downside risks and volatility will also be higher. Nonetheless, assuming historically normal net default rates and spreads over government bonds, they should significantly outperform government debt over the 10yr period. A caveat is that returns are sensitive to the profile of the default cycle, early defaults reduce overall returns. EM debt should also generate outperformance in light of higher current yields and negligible/limited default risk. EM sovereign debt periodically faces elevated liquidity risk when global financial conditions tighten, but fundamental drivers are positive. In the long run, returns on EM local currency debt should also benefit from exchange rate appreciation vs. USD.

The LT Equity Markets Outlook

Moderate global economic growth should be sufficient to generate solid real returns for equities in the coming decade. Decent real earnings growth, reasonable valuations and attractive dividends drive returns. EM markets will produce the strongest returns among regions, underpinned by superior economic growth and a modest re-rating. The below table summarizes the key inputs into my equity markets return estimates. Returns are based on projected earnings growth, anticipated P/E ratios for each market and current dividend yields. Earnings growth is based on projected book value growth and forecast ROE. BV growth is derived from a weighted average of GDP growth in domestic and overseas economies, depending on sector composition and external orientation. As a result, BV and EPSG diverge less across markets than domestic GDP growth rates, reflecting the effects of globalization for many sectors. Accordingly, the gap between EM and DM real GDP growth is 4% per year, but the gap in real earnings growth is a much smaller 1.8%.

Projected ROEs represent our estimate of the long-term sustainable profitability, based on sector composition. ROEs for most developed markets are assumed to be near or slightly below their historical means, in part reflecting lower average ROE in the financial sector in light of expected tighter regulation and private sector de-leveraging. Japan and the EM are the main exceptions since ROEs in the past decade have deviated dramatically from the historical norm and are not assumed to revert to earlier levels. Global ROE is expected to be slightly above its historical average by 2022, reflecting the increasing weight of EM, which also has a superior average ROE. I assume little to no change in the prospective P/E for global equities, despite the fact that current levels are low compared with the average of the past 40 years. The PE ratio for DM stocks remains low in the future given slow growth, while the PE ratio for the EM economies increases moderately to reflect their rising economic clout. This is a conservative assumption, and there could be upside for PE ratios as investors gain confidence in the sustainability of the global economic expansion.

Dividends contribute significantly to equity total returns. Re-invested dividends historically have accounted for a large proportion — in some cases the majority — of total equity returns. They are especially important when slow economic growth restrains earnings gains and PEs are stable. Dividend yields are effectively a “real” yield, and so provide a major boost to total returns over the long-term. Dividends play a less important role in EM total returns given the group’s faster economic and earnings growth. Total returns in USD reflect both the real return in local currency, as well as domestic inflation translated into USD depending on the projected exchange rate. For most DM markets, nominal USD returns are about 2% higher than real returns. But for EM markets, the impact is 4-6%, because of higher domestic inflation and real currency appreciation.

EM markets dominate the total return leader board, with several producing high single-digit real annual returns and low double-digit returns in USD terms. Chinese equities produce stellar real returns, and even better returns in USD as RMB appreciates. Chinese equities benefit from solid earnings growth, a significant upward re-rating of their PE multiple, which is currently depressed, as well as an above-average dividend yield. Euro area stocks are the star performers among the DM markets. Euro area profits and PE ratios are currently depressed because of the sovereign debt crisis, but will rebound if the IMF base-case scenario pans out. Its 4% DY augments prospective returns. Of course, these prospective returns must be weighed against the possibility that the monetary union will break up in the coming decade. Within the region, German equities will likely be superior performers in the coming few years given the relative growth and policy backdrops. However, over a longer-term, the eventual rebound in corporate profits should be stronger in the rest of the region. Investors hoping for a turnaround in Japan will likely be disappointed. While profit growth should be quite strong by global standards (from a low starting point), an ongoing de-rating (i.e. lower PE ratio), will drag down total returns. Japan’s abysmally low ROE warrants a further compression of Japan’s relative P/E multiple. While overall global equity returns should be solid in the coming decade, divergent return prospects will put significant emphasis on country selection.

The LT Current and Commodities Outlook

Global currency markets are destined to undergo massive fundamental change in the next decade and beyond. The USD will remain the world’s dominant reserve currency given the US’ economic, political and military might. However, the rapidly rising EM share of the global economy should gradually translate into a more important role for EM currencies in global trade and FX reserves. This will especially be the case for the RMB as China’s current and capital accounts are liberalized. Accordingly, investment returns from EM currencies (even apart from carry) should be significant in overall portfolio performance.

Relative economic growth, productivity, inflation, international financing requirements and competitiveness drive currencies on a multi-year basis. This favors the USD vs. other DM currencies, and EM currencies vs. DM currencies. The USD should benefit from superior economic growth and competitiveness relative to other DM currencies. Moreover, the real TW USD is low by historical standards, reinforcing that it has upside over the long term, at least versus other DM currencies. The counterpoint is that most other DM currencies will decline modestly against USD in both nominal and real terms. A lower productivity growth, deteriorating relative competitiveness, and more sluggish domestic demand point to moderate declines for EUR, JPY and GBP.

EM currencies should enjoy more pronounced gains, especially given current attractive value. On balance, real per capita GDP — a proxy for productivity growth — increases about 3% per year more in the EM than DM economies, boosting relative competitiveness and putting upward pressure on the EM real exchange rate. Higher EM inflation is a partial offset, but overall i expect a basket of EM currencies to appreciate about 2-2.5% per year in real terms over the next decade (as well as provide attractive carry). EM real currency appreciation should be broad based, but led by China. Ten years out, RMB should be an increasingly important currency, backed by the world’s largest economy and sustained rapid productivity growth. China’s currency appreciation will provide a major boost for DM investors willing to hold RMB-denominated assets.

For Commodities, the secular bull market has matured, and prospective returns will be modest at best 5 . Demand for commodities will continue to grow at a healthy pace, but we expect increased supply to keep a lid on prices over the long haul. A low inflation environment in the next decade means that returns on commodities will markedly lag equities and other risk assets. These commodity price forecasts imply very different relative price structures in the DM and EM economies. By historical standards, commodities will continue to be expensive in the developed world, where incomes grow only slowly. By contrast, commodities will become steadily less expensive in the emerging world because of its rapidly rising incomes. Commodity returns will be materially negative in real terms for EM-based investors.

Good night, my dear friends!