Money Makers

The investment climate promises to be difficult over the next decade, even assuming a reasonable growth backdrop. The starting point of very low real bond yields is especially problematic, but returns from equities will also be subdued by historical standards, according to our latest annual long term returns report.  A structural overweight in equities versus bonds is appropriate in a moderate global growth climate.  The next several years could be especially difficult for portfolio managers, assuming a gradual normalization of interest rates, as bonds could generate losses.

The key investment strategy implications of MRB’s forecasts are:

• Equity and bond returns will likely be negatively correlated in the next several years as interest rates rise.  This implies that DM government bonds will provide effective diversification for periodic equity downside, but at the cost of aggregate portfolio returns.
• EM equities represent the most attractive asset class in terms of real return potential given the depressed starting point of valuations and earnings. History indicates that over time, EM real earnings will broadly correspond with underlying economic conditions, which bodes favorably for the asset class.
• China’s stock market, in particular, is poised to deliver outstanding real returns over the long run for investors willing to tolerate risk, but with a positive view on the country’s ability to navigate its economy onto a more sustainable growth trajectory.
• European equities, including the euro area, Swedish and U.K. markets, also offer comparatively strong returns. Current perceived risk factors imply prospective outperformance if earnings revert toward historical norms (based on the ROE).
• Spread products, most notably U.S. high-yield debt and EM sovereign debt should also generate solid real returns given the decent starting point and should be overweighted within a fixed-income portfolio.

The risk-reward trade-off for stocks and bonds is poor compared with past decades, based on conventional metrics. Equity and bond volatility will likely be high compared with prospective returns in the coming decade.  Arguably, the trade-off for bonds will be worse, with rising yields likely to correspond with an increase in annual volatility even as returns deteriorate (or go negative). The challenge will be greater during the monetary normalization phase of the next several years, with better returns thereafter.

Peter Perkins, MRB Partners

MRB Partners is an independent strategy firm that is widely recognised as one of the most astute in the investment business. Website: www.mrbpartners.com.