Strategic Asset Allocation Outlook
A disciplined process towards understanding the long term drivers of markets can help investors; we suggest a neutral equity position and more exposure to alternative assets and high yielding debt.
Strategic Asset Allocation (SAA) can enhance returns for investors alongside Tactical Asset Allocation. SAA looks at expected returns over 5-10 years, rather than a few quarters. It aims to shift portfolios away from overpriced assets towards those offering better value. To do this we take on the long-term economic outlook for growth, inflation and interest rates around the world, together with a view on asset class fundamentals: term premia, credit spreads, earnings growth and valuation criteria. This allows us to overweight assets offering a higher potential reward for bearing risk, and underweight expensive assets; helping clients to better meet their long-term investment objectives.
Drawing on our economics team and asset class experts throughout our business, we generate a set of expected return forecasts, which we update every six months. We publish these on aberdeenstandardforecaster.com, together with our detailed Long-term Investment Outlook report. We have just completed our mid-2018 update (see chart 1).
The economic outlook has become a little less enticing since our last update in January. The surge in synchronised global growth we saw in late 2017 has faded. The US is still performing well, but the turbo-boost from tax cuts is expected to wane, resulting in more sluggish growth.
However, economies are now running at full capacity nearly everywhere, leading central banks to worry about the risk of inflation, so they have started the process of removing the extraordinary monetary stimulus of the last decade. In the US this has been under way for some time; policy interest rates are at 2% and rising, and the Fed is reversing its previous quantitative easing purchases. Europe and Japan are proceeding more slowly, but the path towards tighter monetary policy is set.
Higher US interest rates and a stronger dollar have also added to the stresses in emerging markets
At the same time, the US has embarked upon trade conflicts with China and other developed economies, increasing economic uncertainty and, if it goes too far, slowing growth. Higher US interest rates and a stronger dollar have also added to the stresses in emerging markets , particularly for more vulnerable economies like Turkey and Argentina.
With a slower growth outlook, tighter monetary policy, a strong dollar and the threat of trade wars, markets have not managed to sustain the confident optimism which fuelled asset prices in 2017. Volatility has returned and global equity prices have moved sideways since February.
Government bond yields continue to be extremely low, particularly in the UK, Europe and Japan. US rates are a little higher, but 10-year Treasuries have not managed to sustain yields above 3%, despite strong growth and strengthening inflation. We expect yields to rise from here, but only slowly and to much lower levels than in past cycles. This reflects the impact of the ongoing global ‘savings glut’ on equilibrium interest rates and compressed term premia. Low starting yields make for very low bond returns. We are particularly negative about the prospects for inflation-linked gilts, a very high duration index. Real yields are unusually low, and markets seem to be over-pricing likely inflation over the coming years. We expect this to correct, with yields shifting higher.
Low government bond returns are a challenge for portfolio construction. For decades the standard approach has been to hold a portfolio of equities and government bonds, perhaps with some exposure to corporate credit and real estate. Government bonds have been excellent diversifiers and previously offered decent returns. Over the last 20 years UK gilts have offered returns above 5%. This traditional approach is far less attractive when gilts offer the 1% or so we expect today. We are now recommending that clients make use of other less conventional sources of diversification.
Investment grade credit can provide some help, but returns here are also much lower than in the past for the same reasons as government bonds. Over the last six months, credit spreads have widened slightly, improving the returns outlook for credit and bringing expected excess returns above government bonds closer to the long-term average.
Default levels are currently low, but as we move to the end of the business cycle over the next few years, our view is that credit spreads are still not providing a particularly attractive reward for these risks.
Alternative credit assets
Given the uninspiring returns available from conventional credit assets, we increasingly look further afield for credit returns. Asset backed securities (ABS) are relatively attractive, given their significantly higher yields for the same level of credit risk and their lower default risks. Some investors will find this sector unappealing because of the sub-prime mortgage backed securities debacle. We take the opposite view: governance standards have greatly improved and, surprisingly perhaps, most ABS assets had extremely low defaults during the financial crisis.
Another bond asset that we find especially attractive is emerging market government debt (EMD), particularly when expressed in local currency (see chart 2).
Local currency EM bonds offer much higher yields (nearly 7%), low default risk and some equity diversification.
Currencies can be volatile but, after falling some 40% in dollar terms in the last two years, they are now cheap, limiting downside risks.
It is true that trade tensions, higher US rates and a strong dollar are creating stress; Turkey’s currency crisis is a case in point. But it is also worth remembering that EMD is a highly diversified mix of economies. Turkey is only 4% of the index, and the bulk of the remainder is much less vulnerable to Turkey’s currency problems. This diversification means that although the value of Turkey’s bonds has plummeted, the overall index is down only 3% year to date/peak to trough. The key point for EMD is that, on our SAA investment horizon, the cumulative compounding of 7% income each year should overwhelm the impact of short-term volatility.
Equity returns are probably past their best for this business cycle. For most of the decade since the financial crisis, double digit equity returns were turbo-charged by rising valuation multiples and rising profit margins. But these tailwinds are petering out; equity valuations are now stretched in the US market, which dominates the global equity index, while profit margins are at all-time highs in the US and near cycle peaks in most other markets. Without further expansion in margins and valuations, equity returns in the mid-single digits are more likely, at least over SAA horizons.
Our SAA approach puts considerable weight on valuations (see chart 3). This means we are now underweight the US market. We do not necessarily expect the momentum driving US technology stocks to fizzle out in the near term, but history suggests that expensive equity regions underperform cheaper ones over the 5-10 year horizons we use for our SAA decisions.
After a strong sell off this year, EM equities are now fairly cheap, although we currently prefer to take EM-risk exposure in bond markets. Japan is also on the cheap side, but slow long-term growth rates lower our expectations for returns. Europe is in the middle of the pack. This means that, by a small margin, UK equities are our preferred region. The UK market is unloved by international investors, mainly due to fears about Brexit. However, the FTSE 100 derives 60% of its revenues from overseas, so will be relatively untroubled by Brexit over our time horizons. In fact, a hard Brexit will drive sterling lower, improving foreign earnings when repatriated to sterling. Inexpensive valuations, and the highest dividend yields of any region, make UK equities, in our view, the best of a sub-par bunch.
Finally we turn to alternative assets. Here, we particularly like infrastructure. Now that government bonds no longer provide a strong source of diversified returns, infrastructure is particularly useful. Infrastructure cash flows are typically fairly insensitive to the fluctuations of the business cycle, so returns have a low correlation with equities and offer some protection in equity bear markets. Listed infrastructure investment trusts provide an easy entry point.
We also increasingly make use of a variety of less conventional sources of diversified returns
We also increasingly make use of a variety of less conventional sources of diversified returns: insurance linked securities and absolute return funds of various kinds, as well as alternative risk premia, which aim to harvest value, momentum, carry and other risk premia. These strategies can offer strong equity diversification, together with risk-adjusted returns materially higher than government bonds.
We also allocate to commercial property, private equity and other less liquid assets for clients who are willing to forgo access to their capital. While the illiquidity premium is less generous than it was a few years ago, we still see a significant premium for these assets.
Asset allocation conclusions
In the past, our SAA strategy was to buy equities when they were cheap in the midst of a recession and retain a strong overweight position through the recovery. Then, as the cycle matured equities became expensive and earnings growth peaked, we gradually rotated into high grade bonds. This provided a store of dry powder, ready to fund our purchase of cheap equities in the bear market. Today, economies are running at full capacity and central banks are tightening monetary policy; earnings are high and valuations full. As a result we have been reducing our SAA overweight to equities, and are now at neutral.
This time there is a twist. Ultra-low government bond yields mean that instead of rotating from equities to high grade bonds, we are rotating to a mix of EMD, ABS, infrastructure and other alternative diversifiers. As chart 1 shows, these offer similar returns to those we expect from equities, but with significantly lower risk.
View the full Global Outlook publication below:
- Strategic Asset Allocation Outlook
- Corporate profits drive equity performance
- Value in the global energy sector
- From Smart Beta to Smarter Beta
- Improving returns by investing in concession infrastructure funds
- Gender Diversity: an economic and strategic imperative
RISK WARNINGThe value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.
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