2014 CAPITAL MARKET ASSUMPTIONS. January SEATTLE LOS ANGELES

Transcription

1 2014 CAPITAL MARKET ASSUMPTIONS January 2014 SEATTLE LOS ANGELES

2 TABLE OF CONTENTS Summary Page 3 Overview of Methodology Page 7 Inflation Page 9 Fixed Income Page 11 Equities Page 17 Alternatives Page 20 Appendix Page 25 2

3 SUMMARY 3

4 SUMMARY Developed equity investors experienced strong gains over the year as investors priced in stronger growth going forward. Developed equity risk premiums narrowed with the S&P 500 P/E ratio rising 18% on the back of implied nominal earnings growth of nearly 6%. In total, the S&P 500 returned a little over 32%, which ranks in the top 15% of all one year returns since Earnings growth, while strong in the U.S. over the past few years, is likely to slow due to profit margins being at all time highs and continued slow top line revenue growth. With the expansion of the P/E ratio and low volatility over the past few years, we wonder how much good news is already priced in. Nominal U.S. equity return assumptions are lower compared to last year due to higher valuation and lower inflation expectations. EAFE equity markets produced an impressive 23%, but were unable to keep up with the U.S. markets and underperformed the U.S. by nearly 9% in While Eurozone economies remain mixed, both the UK and Japan have seen stronger economic growth over the past year. Suppressed equity valuations in these regions result in higher nominal forecast returns relative to the U.S., but our forecast remains slightly below the long term median due to low inflation expectations. EM equity significantly underperformed in 2013, producing a 2.4% return as investors feared slowing growth, a central bank that continues to tighten policy, and strong developed markets. As a result of the significant underperformance, our emerging market forecast is higher than the long term median due to attractive valuations. With the exception of Japan, most developed countries sovereign yields rose during the year as investors anticipated a normalizing of interest rates due to either an increase in growth expectations or a gradual end to quantitative easing. Portfolios with high duration positions were negatively affected with this rise. Our forecast for the total return in rates is higher, reflecting the improved valuations following the rate rise in U.S. breakeven inflation expectations fell over the year indicating that the rise in yields was not due to higher inflation expectations, but because of a demand for higher real yields. Inflation expectations across the developed world are benign. While U.S. short rates remain low today, markets have priced in a faster expectation of tightening compared to one year ago (expected short rates three years from now have risen approximately 1.4% compared to last year). Along with expected rising short rates, our forecast cash return is higher. Credit spreads were mostly tighter in 2013, with the exception of EM debt. Despite the tighter spreads, our forecast return for credit is higher due to the rise in rates not due to expectations of tighter spreads. Commodities once again produced a negative result in 2013 and returned 9.6%. While short term prices can be volatile, we generally expect commodities to return inflation plus cashflow yield. Cashflow yield is higher compared to one year ago and inflation expectations are lower, resulting in a net higher return forecast. Although roll return can be a large contribution to commodity returns, they are not considered in our forecast. Real estate cap rates have continued lower with the rise in real estate prices. Over the long run, we expect no return contribution from a change in valuation. 4

5 SUMMARY OF ASSUMPTIONS: RETURNS Equities Asset Class Index Proxy Geometric Ten Year Return Forecast Arithmetic Standard Deviation Forecast Sharpe Ratio Forecast 5 Ten Year Historical Sharpe Ratio US Large S&P US Small Russell International Developed MSCI EAFE International Small MSCI EAFE Small Cap Emerging Markets MSCI EM Private Equity Cambridge Private Equity Fixed Income Cash 30 Day T Bills US TIPS Barclays US TIPS US Treasury Barclays Treasury 7 10 year Global Sovereign ex US Barclays Global Treasury ex US Core Fixed Income Barclays US Aggregate Bond Investment Grade Corp. Credit Barclays US Credit High Yield Corp. Credit Barclays High Yield Bank Loans S&P/LSTA Global Credit Barclays Global Credit Emerging Markets Debt (Hard) JPM EMBI Global Diversified Emerging Markets Debt (Local) JPM GBI EM Global Diversified Private Credit High Yield bps Other Commodities S&P GSCI Hedge Funds HFRI Fund of Funds Core Real Estate NCREIF Property REITs Wilshire REIT Inflation All returns are gross of fee with the exception of hedge funds. This year we have included both geometric and arithmetic return forecasts. It is important that users of this information understand how we derived it. Our forecast process involves the use of a wide range of data inputs (of a variety of different types) to create geometric return forecasts for individual asset classes this is the process described at length in this document. We use an industry standard formula to convert these to arithmetic return forecasts, and provide both for client use. Investors wishing to produce expected geometric return forecasts for their portfolios should use the arithmetic return forecasts provided here as inputs into that calculation, rather than the singleasset class geometric return forecasts. This is the industry standard approach, but requires a complex explanation only a heavy quant could love, so we have chosen not to provide further details in this document we will happily provide those details to any readers of this who are interested. More broadly, it is important that the user of these forecasts remembers that return forecasts (whoever provides them) are there to provide a guide to the likely future, no more. While we believe that the approach described in this document is an appropriate one to use for those purposes, and that the forecasts resulting from that approach are meaningful and fit for the uses to which they will be put, users of any such forecasts should always bear in mind the fact that the single most difficult thing to predict is the future, and approach that exercise with appropriate skepticism.

6 DISTRIBUTION OF 10-YEAR RETURN FORECAST 25% 10 Year Return 95% Confidence Interval 20% 95% Confidence Interval 15% Return 10% 5% 0% 5% 10% High Volatility Low Volatility 5th to 25th 25th to 50th 50th to 75th 75th to 95th 10 Year Forecast (Geometric) 6

7 OVERVIEW OF METHODOLOGY 7

8 OVERVIEW OF METHODOLOGY Appropriate Frame of Reference Over the short term, capital markets may reflect irrational investor behavior as prices diverge from fair value. Mean reversion may occur over the long run as prices converge to underlying fundamentals due to long term investor rationality. In our opinion, a 10 year outlook is a reasonable time frame to expect fundamental valuation measures to mean revert. Asset Return Methodology Volatility Methodology Inflation Cash Bonds Credit Private Credit Equity 25% weight to the University of Michigan Survey 5 10 year ahead inflation expectation and the Survey of Professional Forecasters (Fed Survey), and the remaining 50% to the market s expectation for inflation as observed through the TIPS breakeven rate Real yield estimate + inflation forecast Nominal bonds: current annualized yield Real bonds: Real yield + inflation forecast Current option adjusted spread + U.S. 10 year Treasury default rate High yield forecast + 2% illiquidity premium Dividends (current yield) + real earnings growth (historical average) + inflation on earnings (inflation forecast) + P/E change (cyclical adjusted P/E) Last ten years of realized volatility Private Equity Small cap forecast + 3% illiquidity premium 20% higher than small cap volatility Commodities Cash + inflation forecast Last ten years of realized volatility Hedge Funds Return coming from traditional beta + 3.0% (alternative beta and alpha) 165% of last ten years of realized volatility Real Estate Cap rate Capex + Inflation forecast Half of REITs volatility REITs Same as private real estate Last ten years of realized volatility 8

9 INFLATION 9

10 INFLATION The market s expectations for 10 year inflation can be inferred by taking the difference between the U.S. 10 year Treasury yield and the U.S. 10 year Treasury Inflation Protected (TIP) yield (referred to as the Breakeven Inflation Rate). While the Breakeven rose in 2012, over the course of 2013 it fell, with the latest breakeven pricing in a 2.2% rate of inflation over the next decade. The latest University of Michigan Survey 5 10 year forward inflation expectation, a survey of about 500 households around the nation, is 2.7%. Historically, this survey of inflation tends to be higher than actual future inflation. A more stable indicator over time has been the Survey of Professional Forecasters (conducted quarterly). The most recent expectation for long term inflation is 2.3%. To develop our inflation forecast, we assign a 50% weight on the 10 year TIPs Breakeven and a 25% weight on each of the two surveys. Based upon the December 31, 2013 data, our 10 year inflation forecast is 2.4%, which is 0.2% lower when compared to last year s estimate, and remains below the long term average. Inflation (%) Count of Inflation Bucket Monthly Breakeven Inflation/UoM Survey/Professional Forecasters Survey Source: Bloomberg; Philly Fed US Rolling 10 Year Average Inflation Histogram Since 1923 Forecast: 2.4% 0 3.5% 2.5% 1.5% 0.5% 0.5% 1.5% 2.5% 3.5% 4.5% 5.5% 6.5% 7.5% 8.5% 9.5% Source: Bloomberg US Ten Year Breakeven Inflation Rate University of Michigan Survey 5-10 Inflation Expectation Survey of Profesional Forecasters Inflation Bucket 10 Average: 3.2%

11 FIXED INCOME 11

12 CASH Earlier this year, Ben Bernanke revealed that the Federal Reserve may taper asset purchases based on data showing economic improvement. As a result, longer rates shot higher as the market anticipated the effect this would have on yields. The U.S. 10 year Treasury ended the year at 3.0%. Current short rates have remained anchored, but short forward rates indicate the market does expect a rise in short rates over the next few years. Traditionally, both the annualized volatility and return of Treasury security increases with the time to maturity (called the yield curve). While the shape of the yield curve can change over time (more or less steep), the steepness of the curve indicates that investors have historically earned a premium for extending duration. Over rolling ten year time periods, the average historical real return to long bonds is 86% higher than the real return to cash. By applying the historical real return relationship between long bonds and cash, we get an 8 bps real return to cash from our current 60 bps real return forecast for long bonds. Adding our inflation forecast of 2.4% results in a nominal return to cash of 2.5%. 10-Year Forecast Cash 2.5% Inflation Forecast 2.4% Yield (bps) Annualized Return Source: Bloomberg 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% Source: MPI 250% 200% 150% 100% 50% 30 Day US Treasury Actives Curve Years Current 6 Month 1 Year Historical Treasury Volatility to Return 30 Yr 7 Yr 10 Yr 5 Yr 3 Yr 2 Yr 1 Yr 90 Day Annual Volatility Average Real Return 86% Higher Real Return 0.10% 0% Cash Long Bond Source: MPI 12

13 RATES Federal Reserve (Fed) quantitative easing (QE) help push rates lower, with 10 yearratesreachinganall time low in Since the historic low, rates have doubled as investors have reallocated into asset classes with the expectation of higher yield/total return. Despite the doubling in yields, investors still expect rates to move higher in the future, with the forward curve indicating the market is anticipating another 40 basis point (bps) rise. Historical analysis shows the forward curve pricing is not the most accurate predictor of where rates are headed. Our forecast of rates is based upon the current yield, with all cash flows reinvested at the current yield. Yield (%) Jan 11 Jan 12 Jan 13 Jan 14 Source: Bloomberg US 10 Year Treasury Yield 10-Year Forecast Yield (bps) Market Estimate of 10 Year Rate 1 Year Out 40 bps rise from current yield US 10 Year Treasury 3.0% 2.0 Inflation Forecast 2.4% 1.5 Real Return 0.6% Market Estimate of 10 Year Rate 1 Year Out Actually Spot Yield Source: Bloomberg 13

14 REAL RATES Real yields rose in line with nominal yields over the year, which indicates that nominal yields did not rise because of higher inflation expectations. While TIPS returns can be volatile given the daily change in the markets inflation expectation, over the long run, its performance is determined by the Consumer Price Index (CPI). As TIPS are quoted in real terms, in order to get the nominal return forecast we add the TIPS current yield to our inflation forecast. Our nominal 10 year TIPS return forecast is 3.1%. US Real Yield 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% -0.2% -0.4% -0.6% -0.8% -1.0% Nominal Yield vs. Real 3.2% 3.0% 2.8% 2.6% 2.4% 2.2% 2.0% 1.8% 1.6% US Nominal Yield -1.2% 1.4% US Real Yield US Nominal Yield Source: Bloomberg Composition of Barclays Capital US TIPS Index Return Year Forecast Return (%) US 10 Year TIPS Yield Inflation Forecast +2.4% Nominal Return 3.1% Inflation Adjustment Coupon Price Change Barclays US TIPS Return Source: DFA 14

15 CREDIT Credit is composed of a bond term premium (duration) and credit spread. It is likely that credit spreads compensate investors for taking on systematic risk which comes in the form of clustered defaults. Since 1973, the average spread to credit has been approximately 150 bps, while its excess return to a like duration treasury has averaged only 72 bps over rolling 10 year time periods. While some of the differences are due to defaults, indices that follow strict rating guidelines may disadvantage investors by immediately selling issues that are downgraded; realizing losses becomes a drag on returns. Our 10 year credit forecast combines the option adjusted credit spread (net of defaults) with the U.S. 10 year Treasury, assuming a constant credit spread over 10 years. 10-Year Forecast Barclays US Option Adjusted Spread +1.1% Net Default (10 bps with 40% Recovery) 0.06% US 10 Year Treasury +3.0% Nominal Return 4.0% Inflation Forecast 2.4% Credit Spread Investment Grade Credit Spread 150 bps average Investment Grade Spread (BC US Credit Yld - IA SBBI US IT Govt Yld) Average IG Spread Source: MPI Excess Return 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% Rolling 10 Year Excess Return 72 bps average Real Return 1.6% Source: MPI Rolling 10 Year Excess Return (BC US Credit - IA SBBI US IT Govt) Average Excess Return 15

16 CREDIT SUMMARY Index Method Spread to Default Assumption Recovery Assumption IG Core High Yield Bank Loans BC US Credit OAS + US 10 year US 10 Year Treasury BC US Aggregate OAS + US 10 Year US 10 Year Treasury BC US High Yield OAS + US 10 Year US 10 Year Treasury EM Debt (USD) EM Debt (Local) S&P LSTA JPM EMBI JPM GBI LIBOR + Spread LIBOR OAS + US 10 Year US 10 Year Treasury Current Yield Private Credit BC US High Yield + 2% High Yield + 2% illiquidity premium 0.1% 0.1% 4.0% 4.0% 0.5% 0.5% 40% 40% 40% 60% 40% 40% Spread 1.1% 1.1% 3.8% 4.9% 3.1% Yield 6.9% Risk Free Yield 3.0% 3.0% 3.0% 0.2% 3.0% Effective Default Nominal Return Inflation Forecast 0.06% 0.03% 2.4% 1.6% 0.3% 0.3% 4.0% 4.1% 4.4% 3.5% 5.8% 6.6% 6.4% 2.4% 2.4% 2.4% 2.4% 2.4% 2.4% 2.4% Real Return 1.6% 1.7% 2.0% 1.1% 3.4% 4.2% 4.0% 16

17 EQUITIES 17

18 EQUITIES Historical equity returns can be broken down into earnings growth, dividend yield, inflation, and repricing. Over the very long term, repricing represents a small portion of return to equity investors, but over shorter time frames, the effect on return can vary considerably If investors are willing to pay more for earnings, it could signal that investors are more confident in positive earnings growth going forward, while the opposite is true if investors pay less for earnings. It is somewhat surprising that investor confidence varies so much given that the long termearningsgrowthisrelatively stable. Investor confidence in earnings growth can be measured using the Shiller P/E Ratio. In short, if the P/E ratio is too high/low relative to history, we expect future returns to be lower/higher than the longterm average. Implicit in this analysis is the assumption that P/E s will mean revert over 10 years. We make a conservative repricing estimate given how widely repricing can vary over time. We then skew the repricing adjustment because the percentage change in index price is larger with each incremental rise in P/E when P/E s are low, compared to when they are high. Shiller P/E Percentile Bucket Lower P/E Upper P/E Repricing Assumption Lower 10% % 10% 20% % 20% 30% % 30% 45% % 45% 55% % 55% 70% % 70% 80% % 80% 90% % Top 10% % S&P 500 Return Composition (%) Return Composition (%) Trailing Ten Year S&P 500 Return Composition (%) Ten Year US Inflation Growth Ten Year S&P 500 Real Earnings Growth S&P Year Rolling Return Source: Shiller Web Site; Wurts' Calculation 12 Repricing S&P 500 Return Composition (%) Source: Shiller Web Site; Wurts' Calculation 18 Ten Year S&P 500 Repricing Return Starting S&P 500 Nominal Dividend Yield Present Present Last Ten Years S&P 500 Repricing Gains/Losses S&P 500 Average Dividend Yield S&P 500 Real Earnings Growth US Inflation Growth S&P 500 Annualized Return 7.7

19 EQUITY SUMMARY US Large US Small EAFE EAFE Small EM Index S&P 500 Russell 2000 MSCI EAFE Large MSCI EAFE Small MSCI EM Method Building Block Approach: current dividend yield + historical average real earnings growth + inflation on earnings +repricing Current Shiller P/E Ratio Regular P/E Ratio Shiller P/E Expansion 17.9% 28.3% 13.3% 14.0% 2013 Regular P/E Expansion 22.6% 28.1% 14.4% 9.5% 5.1% Current Shiller P/E Percentile Rank 87.0% 94.0% 21.2% 8.0% Current Regular P/E Percentile Rank 60.5% 100.0% 50.1% 30.0% 13.2% Average of P/E Methods Percentile Rank 73.8% 97.0% 35.7% 30.0% 10.6% 2013 Total Return 34.3% 38.8% 23.6% 29.8% 2.4% 2013 Implied Nominal Earnings Growth From Regular PE 5.7% 6.7% 4.4% 20.0% 0.0% Shiller PE History Not Enough History 2005 Long Term Average Shiller P/E Current Dividend Yield 1.9% 1.2% 3.0% 2.3% 2.6% Long Term Average Real Earnings Growth 2.1% 3.0% 2.1% 3.0% 3.1% Inflation on Earnings 2.4% 2.4% 2.4% 2.4% 2.4% Repricing Effect (Estimate) 0.5% 1.5% 0.8% 0.8% 2.0% Nominal Return 5.9% 5.1% 8.3% 8.5% 10.1% Inflation Forecast 2.4% 2.4% 2.4% 2.4% 2.4% Real Return 3.5% 2.7% 5.9% 6.1% 7.7% 19

20 ALTERNATIVES 20

21 PRIVATE EQUITY Private equity and public equity returns are historically correlated because the underlying economic forces driving these asset class returns are quite similar. The return relationship between the two can vary in the short term, but over the long term, the return to a private equity index should outperform public equities for two main reasons: 1. The illiquidity premium rational investors demand to hold a less liquid investment 2. The upwardly biased performance of the index because of selection biases related to voluntary reporting We estimate an illiquidity premium of 3.0% on top of our U.S. small cap forecast of 5.1%. Excess Return (%) Rolling 10 Year Private Equity Excess Return (PE Small Cap) Private Equity Outperform Average = 6.1% Private Equity Underperform Rolling 10 Year Private Equity Excess Return Average 10 Year Excess Return Source: MPI 6 Private Equity Excess Return Year Forecast Small Cap Forecast +5.1% Illiquidity Premium Estimate +3.0% Excess Return (%) Nominal Return 8.1% 1 Inflation 2.4% Real Return 5.9% 0 10 Year 15 Year 20 Year 25 Year Cambridge Associates US PE Return - Russell 2000 Return Source: MPI 21

22 HEDGE FUNDS Traditional betas explain approximately half of the variation in hedge fund net of fee returns, while the remaining unexplained portion can be attributed to alternative betas, skill, luck, or biases in the index. We develop the systematic component of return by applying the historical weights of each traditional beta to our capital market assumptions. As estimated by Ibbotson Chen Zhu 2010, the annualized unexplained portion of net of fee return is approximately 3.0%, which is statistically significant. We add this estimate to our estimate of return coming from traditional betas to get a total net of fee return. Traditional Betas Weight 2014 CMA (Arithmetic) 10-Year Forecast Equity (S&P 500) 32% 6.9% 2.2% Bonds (US Treasury) 21% 3.3% 0.7% Cash 89% 2.5% 2.2% Traditional Beta Nominal Return 3.7% Alternative Beta, Skill 3.0% Nominal Return (Arithmetic) 6.7% Inflation 2.4% Real Return 4.3% Returns Explained by Systematic Factors Equity market betas Other traditional betas (bond, credit) Alternative betas (value, carry, momentum, volatility) Returns Not Explained by Systematic Factor Skill Luck Biases Ilmanen, Antti. Expected Returns Historical Breakdown of Traditional Beta Sum of Betas Cash Bonds Stocks Ibbotson Chen Zhu

23 PRIVATE CORE REAL ESTATE/REITS Performance of the NCREIF property index can be decomposed into an income return (Cap Rate) and capital return. The return coming from income has historically been more stable than the return derived from capital changes. The Cap rate is the ratio earnings less expenses to price, and does not include extraordinary expenses. A more accurate measure of the yield investors receive should include non recurring capital expenditures; we assume a 2.0% capex expenditure. We also assume income growth will track inflation as inflation is passed through to rents. Over the last ten years performance between private real estate and REITsissimilar,althoughREITshaveexperiencedalowerSharpe ratio due to higher volatility. Compared to private real estate, REITs should provide a higher return due to leverage and a lower return because of liquidity. We assume the effects of leverage and liquidity offset each other, therefore are forecast for private real estate becomes are forecast for REITs. REITs 10-Year Forecast Nominal Return Forecast 6.5% Inflation 2.4% Real Return 4.1% NCREIF Property Index Return Composition (%) Trailing Ten Year NCREIF Property Index Return Composition (%) Income Returns are Relatively Stable 10 Year NCREIF Property Capital Return 10 Year NCREIF Property Income Return 10 Year NCREIF Property Total Return Source: NCREIF Capital Depreciation Private Real Estate 10-Year Forecast Current Cap Rate +6.1% Capex assumption 2.0% Income Growth (Inflation) +2.4% Nominal Return 6.5% Inflation 2.4% Real Return 4.1% 23

24 COMMODITIES Commodity returns can be decomposed into four sources: collateral return (cash), inflation, spot changes, and roll yield. Roll return represents either the backwardation or contango present in futures markets. Backwardation occurs when the futures price is below the spot price, which results in an additional profit. Contango occurs when the futures price is above the spot price, and this results in a loss to commodity investors. Historically, futures markets fluctuate between backwardation and contango. Although roll return can be a large contribution to commodity returns, they are not considered in our forecast as there is no consistent methodology to forecast roll return. Over the most recent 10 year period, roll return has been negative, contributing 12% to the S&P GSCI total return. Our 10 year commodity forecast combines collateral (cash) return with inflation to arrive at the nominal return, and subtracts out inflation to arrive at the real return. 10-Year Forecast Collateral Return (Cash) +2.5% Roll Return +0.0% Inflation +2.4% Nominal Return 4.9% Inflation 2.4% Real Return 2.5% S&P GSCI Return Composition (%) S&P GSCI Return Composition (%) Ten Year Roll Return Ten Year Cash Return Ten Year US Inflation Growth Ten Year S&P GSCI Spot Return Ten Year S&P GSCI Rolling Return Trailing Ten Year S&P GSCI Return Composition (%) Source: MPI, Wurts' Calculation S&P GSCI Return Composition (%) Present Last 30 Years Last 20 Years Last 10 Years Roll Yield Return Cash Return US Inflation Growth Spot Return S&P GSCI Return Source: MPI, Wurts' Calculation

25 APPENDIX 25

26 2014 VERSUS 2013 RETURN FORECAST 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 0.5% 1.0% 1.5% 2.0% 2014 versus 2013 Forecast 26

27 CORRELATION ASSUMPTIONS Cash US Large US Small Developed Large Developed Small EM PE TIPS US Global Treasury Sovereign US Core US Credit US HY Bank Loans Global Credit EM USD EM Local Commodities Hedge Funds Real Estate REITs Inflation Cash 1.0 US Large US Small Developed Large Developed Small EM PE TIPS US Treasury Global Sovereign US Core US Credit US HY Bank Loans Global Credit EM USD EM Local Commodities Hedge Funds Real Estate REITs Inflation Note: Correlation assumptions are based on the last ten years. 27