BY ROB ARNOTT AND MIKE AKED
As we bid goodbye to 2019 and welcome a new decade, it’s time to reflect on what the last decade has taught us about capital markets and to look forward into the future. As always, a loud buzz is building among media pundits and market prognosticators who are offering a flood of economic and investment forecasts and predictions. This buzz includes a lot of “nowcasting,” explaining what has happened, presented as if it were a forecast of the future, and it is not at all helpful.
Over the next decade, based on our empirically informed understanding of capital markets, we expect both Australian and emerging market equities to outperform the remaining developed market equities, the US market in particular. Our forecast is that emerging markets will significantly better inflation at a 5.2% annualised real return, just ahead of our domestic market set to deliver a 4.5% annualised real return, over the next decade.
Our models tell us developed equities are expected to tread water, delivering 0.8% a year in real terms, underpinned by the expectation that US equities will lose 1.3% a year in real terms for the next decade. All can access these forward-looking data using the Asset Allocation Interactive (AAI) tool on our website.
We understand some investors may be disappointed with our capital market expectations, especially given the global equity returns of the last decade, but we believe these forecasts capture the forward-looking reality of capital markets, given current conditions. We encourage investors to have realistic expectations. Realistic, to be clear, does not mean conservative for the sake of creating a buffer against disappointment, but rather an unbiased view of the future—as likely to surprise to the downside as to the upside—so that they can invest and plan accordingly.
The Research Affiliates AAI forecasts, based on an empirically driven quantitative model, do not highlight any asset class as having a current annualised expected real return in excess of 10% over the coming decade. Emerging market equities are at the high end of expectations, sporting an annualised 5.2% real return throughout the 2020s. The diversifiers in any portfolio—bonds, government and corporate, both here and globally, as well as commodities—look particularly disappointing. The current yield on Australian government bonds is within a rounding error of the expected rate of inflation. Global markets offer a similar situation. We wish we could be more exuberant, but it would be a disservice to all if we ignored the facts.
We have ignored the tendency to nowcast in producing these forecasts and instead have relied on the fundamental drivers of returns, not history, which can mislead.
Why is nowcasting so prevalent? Nowcasting appears to be informed: an analysis of the drivers behind recent events will certainly sound right. Even more attractive, it’s crowded and safe, with limited risk for reputational damage. The problem with nowcasting, however, and why it often fails as a forecast, is markets move based on surprise.
This self-evident and self-affirming quality is what makes nowcasting dangerous to our financial health. If a trade war has moved markets, they were moved because the trade war was a surprise to the market consensus; if a continued trade war is the new consensus, it’s already in the price and won’t move markets in the future. Indeed, the market-moving surprise could be either a sharp escalation of the trade war or dissipation of trade tensions.
At best, most nowcasting is noise. At worst, it positions us to be hurt badly if the market-moving surprise dissipates or reverses, and it risks inviting us to chase a trend, rather than taking on informed maverick risk.
As we look back, the most recent decade has had an extraordinary place in modern history. Since the end of World War II, and zeroing in on the United States for this application, the 2010s recorded the lowest inflation, the lowest average yield on 10-year US Treasuries, and a dramatic reduction in civilian unemployment. The global equity market returned nearly 10% a year in real terms (i.e., net of inflation) for an Australian investor, while global bond returns came in at 2.9% after inflation, wrapping up a three-decade decline in bond yields since the high inflation of the pre-Volker era.
One asset class’s performance in the 2010s is worth highlighting—high-yield bonds. At the center of the 2007–2009 global meltdown, high-yield has witnessed a very strong recovery over the last decade. US high-yield bonds (hedged into AUD) outperformed our own equity market with real returns of 7.5% a year.
Past is not prologue, however. Past returns are poor—even perverse—predictors of future returns. Investors should not expect a repeat of this post-crisis performance in high-yield bonds. The current yield on these lower-credit-rating bonds is barely above the expected losses from the companies that back them. If high-yield bonds have been a success story since the global financial crisis, we should not expect more of the same as we step into the 2020s.
Said another way, the price of an asset matters: richly priced assets tend to deliver underwhelming returns, while relatively inexpensive assets are better positioned to deliver healthy returns over the medium to long term. As prices rise, delivering high historical returns, yields fall, requiring us to revise down, not up, future returns.
Rob Arnott is founder and chairman of the board and Mike Aked is director of research for Australia.