Market strength and the impact on our return assumptions
Keeping 2019 in perspective
Growing concerns over recession risks had rattled equity markets late in 2018 while depressing government bond yields. At the start of 2019, few would have expected equities and bonds to post strong double-digit returns for the year to come. Yet they did just that. Galvanized by massive global interest rate cuts and greater central bank liquidity injections which put recession risks in the shade, equity markets rallied strongly and were able to effectively combat significant headwinds in the form of escalating trade conflict between the U.S. and China, a rapid freeze in global trade and a deepening global economic slowdown. The S&P 500 returned some in 2019, but other equity markets were not outdone by much.
Furthermore, other asset classes beyond equities delivered strongly too. Demonstrating that this was no ordinary market rally was what happened at the other end of the risk spectrum to equities. Government bonds defied conventional wisdom and produced strong returns too, some of the best risk-adjusted returns in the markets (the US long-duration government bond index delivered almost 15%). The same rang true for gold, a ‘traditional safe-haven’, which returned about 18% in the year.
Of course, a moment spent looking behind the numbers shows that taking an arbitrary window like a calendar year can hide the underlying picture. 2018 had been a turbulent year and finished with a big sell-off, so some part of 2019 strength was part relief-rebound. Therefore, taking 2018-19 together shows a rather different picture to just looking at last year in isolation – global equity indices doing about 5% per annum over the two-year period instead of the gain five times larger that appears from looking at last year alone. All that said, the 2019 gains were impressive.
Pre-eminent though the US Federal Reserve’s three rate cuts last year were in market impact terms, the monetary easing trend went far wider. Focusing on G20 economies, the 2018 trend towards rate rises completely reversed in 2019, with most central banks moving to cut rates (see chart). After such a difficult 2018, this was healing balm to all asset classes, a central bank Midas touch in action not seen on this scale since the aggressive monetary response to the 2008 financial crisis. It revived spirits in very risky and troubled asset markets like equities and high yield, easing fears of global recession. But it energised bond bulls too, who anchored low yield expectations to lower central bank rates and a view that lower rates were more likely to persist.
How do these market movements affect our long-term return expectations?
As we discuss throughout this paper and reflecting an essential attribute of the way we construct our capital market assumptions, the price that you pay today for an investment will have a strong bearing on expected future returns. Significant market appreciation in 2019 has led to lower return expectations across the board across the asset class spectrum. We show the impact on a stylised "balanced" portfolio that only contains 60% U.S. equities and the remaining 40% invested in U.S. long-duration fixed-interest government bonds. With our volatility and correlation assumptions unchanged since 2018, the impact on the U.S. equity-bond frontier calculated using our assumptions is driven purely by the change in return expectations. This is the cause of the downward shift since 2018.
This, however, is not simply a one-year phenomenon. Though equities and risky assets have had some setbacks on the way, by and large, they have had a very successful decade. So, have bonds and so called ‘safe assets’. The upshot of that has been falling expected returns in such a balanced portfolio setting. Seen this way, 2019 was merely a good and strong example of this long-term trend in action, given the magnitude of market strength across the asset class spectrum. In fact, expected returns for such a balanced portfolio have been falling almost throughout the last decade.
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