Schroders On the horizon Medium term asset class forecast

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1 January 2013 For professional investors only Schroders On the horizon Medium term asset class forecast James Bilson, Economist, Schroders Short-term forecasting of the performance of asset classes is made especially difficult by the volatility of economic data, the consequences of unpredictable events and the very nature of financial markets. As an agglomeration of human reactions, markets are prone to both panic and euphoria with little apparent rhyme or reason. In the medium term, however, we see overshoots corrected and long-term relationships moving back into sync allowing us to make reasonable forecasts for the performance of equities, bonds and other assets over this timeframe. We use a seven-year window for forecasting returns, which is an average economic cycle, based on a methodology suggesting that over this horizon any misalignment will be corrected and long-term relationships re-established. In this paper, we give our forecasts for major asset classes over the next seven years, with a brief outline of our methodology, before examining how our current forecasts sit in an historical context. We also look at the assumptions behind our forecasts, and examine the possible risks to them. A brief outline of our methodology The foundation of our seven-year forecasts is our assumption for the returns on cash, which we forecast for Japan, the UK, the US and the eurozone. Since short-term interest rates are currently pinned down by central bank policy rates, explicit forecasts for cash are relatively straightforward. Similarly, for government bonds, we forecast ten-year gilt, bund and treasury returns via explicit yield assumptions during the period. We assume a portfolio of bonds that is rebalanced such that rising yields would increase the income return on newly purchased bonds whereas existing bonds would suffer as, by definition, a rising yield leads to a capital loss. The nature and timing of the changes in the shape of the yield curve is therefore important in determining the returns on these securities. Our equity return forecast relies on two assumptions first, that over a seven-year period real earnings per share revert to their long-run trend level; and second, that valuation metrics (such as the price-earnings ratio) return to a long-run average. For example, if real earnings are currently above trend, we will forecast earnings growth below trend over the forecast horizon, which negatively impacts returns. If equities are cheap in an historic context, there is scope for a rise in the price-earnings ratio, which is positive for returns. Sometimes these two drivers can offset each other. Our return forecast for corporate bonds uses the historic relationship between US real GDP growth and credit spreads over risk-free assets (government bonds), for both investment grade and high yield, which are combined with our forecast returns on the respective sovereign bonds. A similar methodology is used for emerging market debt.

2 We forecast commodity returns using our nominal cash returns, the roll yield 1 and the excess return from index rebalancing. Finally, we assume private equity earns an excess over MSCI World equity returns, while hedge funds deliver a listed equity-like return. Latest forecasts Our forecasts for the period between June 2012 and June 2019 are shown in table 1. We have very low return assumptions for both cash and sovereign bonds for all developed economies. This is simply the result of ultra-loose monetary policy, which is expected to remain in place for several more years, as indicated by the US Federal Reserve s September 2012 decision to extend its low rate guidance through to mid Even allowing for a normalisation in policy rates in the latter part of our forecast window, we expect a low rate of return on cash. Table 1: Schroders' seven-year returns forecast Currency Nominal Inflation Real Cash % p.a. US USD UK GBP Euro EUR Japan JPY yr Government Bonds US USD UK GBP Euro (Germany) EUR Equity US (S&P500) USD UK (FTSE All Share) GBP Europe ex-uk (DS) EUR Japan (DS) JPY Pacific ex-japan (DS) Local Emerging Markets (DS) Local Global (MSCI World) Local Corporate Bonds US High Yield USD US Investment Grade USD UK Investment Grade GBP EU Investment Grade EUR Alternatives EMD$ USD Commodities USD Private Equity GBP Hedge Funds USD Source: Schroders, July Inflation refers to the Consumer Price Index (CPI). All returns are Total Returns i.e. include the impact of reinvesting any dividend or coupon income. DS refers to DataStream indices. This easy monetary policy also impacts our forecasts further out the yield curve. Though our explicit forecast is for yields to stay at exceptionally low levels for a while longer, in the medium term we expect to begin to see a normalisation in yields. This would lead to capital losses (since bond prices and yields are inverse), and this explains our low forecast returns for bunds, gilts and treasuries. 1 Investing in commodity futures means rolling positions forward as futures contracts come up to expiry so as to avoid delivery of the underlying commodity. The roll yield is the return from rolling the futures positions forward. If the futures curve is in contango (futures prices are higher than spot prices) the roll yield is negative. If the futures curve is in backwardation (futures prices are lower than spot prices) the roll yield is positive. 2

3 Turning to risk assets, we are much more bullish on the medium-term outlook for equities. In the US, the historically low level of valuations provides scope for higher returns going forward as the market re-rates to a level more in line with its historical average. These returns are dampened, however, by the currently high levels of earnings, which under our methodology implies negative real earnings growth over the next seven years to bring us back in line with the long-run trend. Inflation estimate methodology Our estimate of inflation over the seven year horizon is the geometric average of our forecast for inflation in each period. Explicit forecasts for inflation in the first couple of years of the period have greater clarity than those later in the period. We can look at influences such as the unemployment rate, the output gap and futures prices for agricultural, metals and energy prices to gauge a reasonably accurate profile of inflation over the next 18 months. Given the current weakness in activity, elevated unemployment rate and stable commodities futures prices, it is probable inflation will remain low across the developed world in the short term. Of course, shocks (such as oil price spikes via Middle Eastern tensions) would alter this; but are literally unpredictable. Further out inflation is more difficult to forecast, as the power of futures contracts to act as a guide to spot prices of commodities diminishes as we go further out the curve. Moreover, we have less clarity of vision with respect to the drivers of internally generated inflation - the output gap, inflationary expectations, the unemployment rate and general wage bargaining conditions. Thus, over a medium term horizon (greater than two years) we generally assume inflation returns to a trend rate. We believe it is reasonable to assume that the trend rate of inflation, especially in the UK, is a little higher than the early part of the new millennium (closer to 3% than 2%). Firstly, we no longer enjoy the benefits of importing goods deflation from emerging market economies, which we did for much of the early 2000s, and this means the new equilibrium inflation rate for goods is higher (and positive). Secondly, we believe that policymakers are now more prepared to see inflation exceed the target for a significant period of time. While the inflation target remains at 2% for CPI, the frequency with which inflation has overshot this in the past five years means that the inflation tolerance is likely to have increased somewhat. In contrast, however, emerging markets have both drivers of returns (valuations and earnings growth) pointing in the same positive direction, since real earnings have dropped below trend in the past year. We allow for an environment in which world growth is subdued over our forecast horizon, as a result of the global de-leveraging process, by making a downward adjustment to the previous trend rate of growth in emerging market earnings. Even with this factored in, the attractive valuations and high growth in real earnings leads us to predict strong growth in the total return on emerging market equities. Though a nominal return of over 20% seems extremely high, it is worth considering that in the period June 2005 to June 2012, which included a 60% drawdown during the financial crisis, the annualised nominal total return on the benchmark index was almost 12%. As chart 1 (below) shows, the previous seven years saw four periods 2 where the annual total return exceeded our current forecast of 22.5%, on some occasions substantially so. Only the huge drawdowns, initially following the Lehman bankruptcy and latterly from the eurozone crisis, caused annualised returns over the entire horizon to be below 20%. Assuming we avoid further crises of this magnitude in the forthcoming seven years, we believe our returns forecast for emerging market equities looks realistic. 2 Labelled , etc. since our forecast runs from June-June 3

4 Chart 1: Our forecast is large, but not unrealistic given recent history Annual nominal total return 60% 40% 20% 0% -20% -40% EM equities nominal total return forecast Source: Thomson Datastream, Schroders, 11 October Investing in emerging market equities, of course, is no free-lunch. The generous returns on offer are available only to those investors willing and able to stomach the volatility associated with high-beta assets. Using monthly total returns data since 1995, we find that the annualised volatility on emerging market equities is around 24.4%, which is high when compared to the S&P 500 (16.8%) and the FTSE All-Share (15.2%). Our forecast for corporate bonds is weaker than for equities, which is to be expected on a risk-return basis. Part of this is simply a reflection that returns to credit are considered in terms of excess returns over bonds, whereas equity returns are forecast on a standalone basis. Though we expect global growth to remain moribund over the next couple of years, which is often considered the sweet-spot for investment grade corporate bonds, we feel the more compelling valuations offered by equities should see them outperform over our seven year horizon. Chart 2 below shows the performance of the asset classes in the last seven years against our forecasts for the next seven 3. It is clear that the last seven years have been exceptionally good for bonds, which have outperformed equities in the US, UK and Europe ex UK. This is no surprise, given the tumultuous period we have just experienced. In the wake of a severe financial crisis and global recession, equities have performed poorly. The enormous reductions in policy interest rates (over 5% since 2007 in the UK) and unconventional monetary easing across the developed world has driven yields down and bond prices up to historic levels to provide a generous return. Of course, we consider here only three sovereign bonds, all of which have had returns aided by their safe-haven status and a flight-to-quality. Nations that have been beleaguered by concerns over their creditworthiness have seen their bonds generate low or negative nominal returns over this period. 3 Both run June-June 4

5 US UK Euro Japan US UK Euro US UK Europe ex UK Japan Pacific ex Pacex Japan Emerging World US HY US IG UK IG EU IG EMD$ Commodities Private Equity Hedge Funds Schroders Medium term asset class forecast Chart 2: Projected nominal returns versus recent history Nominal % (per annum) Cash Bonds Equity Credit Alternatives Source: Thomson Datastream, Schroders, 11 October What we can learn from history At a time where global growth is anaemic and market volatility persists, it may not be obvious why we believe equities will perform so well over the next seven years. History, however, provides a clue. Looking back at previous seven year windows using UK data, equities have generally outperformed gilts (chart 3). The exceptions to this, however, are the periods and , with strikingly similar characteristics. In the 1920s prosperity was rising, before a massive financial crisis induced a deep recession and muted recovery, with output below peak for several years and persistently high unemployment. Sound familiar? Chart 3: The outperformance of gilts is rare Nominal returns (%, annualised) 25% f19 forecast 20% 15% 10% 5% 0% -5% Source: Barclays Equity Gilt Study 2012, Thomson Datastream, Schroders, 11 October Gilts Equities 5

6 As chart 3 shows, the period immediately before, during and after the Wall Street Crash of 1929 was an excellent one for gilts at a time when equity returns were dismal. The following seven years, however, saw a return to the outperformance of equities that lasted until the period. Interestingly, after such a strong performance where yields were driven down to multi-decade lows, gilt returns over the next two periods got progressively worse. In the immediate aftermath of WWII they delivered a negative nominal return, despite a chronic recession caused by demobilisation and reorientation away from a war economy. Though the returns on equities during this period were far from stellar, they outperformed bonds by around 6%. After the 1930s gilts recorded a negative real return (on a rolling seven year basis) for the overwhelming majority of the subsequent fifty years (chart 4). Chart 4: Historic real return on gilts and equities Real seven year annualised return (rolling window) 25% 20% 15% 10% 5% 0% -5% -10% -15% Gilts Equities Source: Barclays Equity Gilt Study 2012, Thomson Datastream, Schroders, 12 October Forecast risks As with all forecasting, we are subject to risks surrounding our assumptions, some of which we can identify and others which are unpredictable in the truest sense of the word (i.e. Donald Rumsfeld s unknown unknowns ). At the forefront of the identifiable risks are the possible outcomes in Europe. We do not expect a complete dissolution of the single currency. Were it to occur, however, a full break up would have a cataclysmic impact on global banking systems, trade and output, and equity returns would be dire. Predicting what would do well in such an environment is not easy, but real assets such as gold would likely be seen as a haven. A second risk occurs via our assumptions about the future growth rate of the global economy. While we forecast growth to be positive but insipid in the upcoming years, we assume it will approach trend towards the middle of our forecast horizon. But if the global economy experiences something akin to Japan s lost decade, with low nominal growth and a deflationary threat persistent, equity returns would not match our expectations, despite the attractive valuations. In this scenario, we would continue to see bonds outperform equities and nominal yields head lower. On the contrary, some investors fear that the world economy may regain buoyancy sooner than we, and policymakers, anticipate, leading to a significant increase in inflation as the enormous increase in the supply of money across the globe is put to work. In such a scenario, we would see bond yields rise more sharply, leading to capital losses. Although, it is possible that nominal returns may still be positive (depending on the timing of the losses), it is likely that real returns will suffer significantly (from an already negative base). Similarly, although this scenario may be supportive for the nominal return on equities, as nominal earnings growth may be strong, real returns on equities are also likely to suffer. 6

7 Finally, there is a risk that our emerging market equity forecast is on the optimistic side. As explained earlier, our expected return is high due to both valuations (emerging equities look cheap relative to their history) and strong earnings growth (which have fallen below trend). If either trend earnings growth is not as strong as we forecast (in spite of our downward adjustment to reflect the weak external environment) or equities do not re-rate to previous levels, realised returns will come in short of our expectations. Conclusions In the aftermath of a global financial crisis, and with a need to de-leverage, developed economies are currently experiencing a period of weak activity, high unemployment and substantial policy uncertainty. This has been weighing on investor sentiment and generating volatility. In these circumstances, it is far from clear that risk assets will outperform, and a myopic standpoint may well suggest steering clear and investing in safe assets. Taking a medium-term perspective, however, there appears to be significant value in equity markets across the globe, both in an absolute and relative sense. With interest rates at record lows, and policymakers eager to maintain this, we predict that the nominal return on major sovereign bonds in the next seven years will be very meagre, and negative in real terms. Equities, however, should offer a generous return in both nominal and real terms over this horizon, with favour going to the high-growth areas such as emerging markets and Pacific ex. Japan 4. As well as the threat of a full eurozone breakup, the risk to this forecast is that, even late in our forecast horizon, growth rates have not returned to pre-crisis levels and remain subdued. In this scenario, highly attractive valuations do not guarantee respectable returns (Japanese equities have looked attractive for the better part of two decades, and have performed miserably). Attractive valuations are a necessary, but not sufficient, condition for equity outperformance. Important information The views and opinions contained herein are those of the Schroders Economics Team, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. Exchange rate changes may cause the value of overseas investments to rise or fall. Less developed markets are generally less well regulated than the UK; they may be less liquid and may have less reliable custody arrangements. Investors should be aware that investments in emerging markets involve a high degree of risk and should be seen as long term in nature. General Forecast Risk Warning The forecasts stated in the document are the result of statistical modelling, based on a number of assumptions. Forecasts are subject to a high level of uncertainty regarding future economic and market factors that may affect actual future performance. The forecasts are provided to you for information purposes as at today's date. Our assumptions may change materially with changes in underlying assumptions that may occur, among other things, as economic and market conditions change. We assume no obligation to provide you with updates or changes to this data as assumptions, economic and market conditions, models or other matters change. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No England. Authorised and regulated by the Financial Services Authority. For your security, communications may be recorded or monitored. 4 Australia, New Zealand, Singapore & Hong Kong 7