European investors have not had a very good experience investing in equities lately. One question is whether or not equities will deliver strong future returns relative to other asset classes. We have looked at this not in a tactical sense – what are returns likely to be over the next year – but in a strategic sense – what kind of returns can we expect over the next five to 10 years.
These return expectations, along with expected volatilities and correlations, appear in the table. We believe that equity returns around the world will generally be modest in euro terms over the next five to 10 years. We also believe that the euro will likely appreciate versus the $ over a longer-term horizon, detracting perhaps 1% pa from US asset returns for a euro-based investor.
In terms of specific regions, we expect European equities to offer modestly positive returns. Value equities ought to perform more in line with growth equities than we have seen in the last five years in Europe, while we project small-cap equities may provide modestly higher returns than large-cap European equities. Inflation should remain relatively low.
We expect US equities to underperform, given still-high valuations and the probability of modest earnings growth over the next few years. We expect emerging equity markets, which are one of the most volatile asset categories, to also provide some of the best returns. Fixed income returns, both US and euro, should be competitive with equities, although high yield bonds may offer added returns due to unusually high credit spreads currently. Japanese fixed income remains a long-term worry, and even though near-term risks are limited, we would be underweight there.
All of the equity forecasts were generated utilising our proprietary framework with consistent assumptions, including that earnings growth in various equity categories will be close to their historical averages of 6% nominal, and valuation ratios will tend to move towards their long-term means. Some adjustments were made if current earnings were far from their longer-term normalised values.
These return projections, and the associated volatility data, suggest the following for an investor with a low to moderate level of risk tolerance:
o Significant exposure to emerging markets, small stocks in Europe, and high yield fixed income instruments.
o A balanced approach to value and growth allocations in the US or Europe.
o Some indexed gilts or other inflation-indexed bond instruments.
o Lower equity allocations than were common in the 1990s, with limited exposure especially to US equities.
o Some exposure to real estate or private equity when appropriate vehicles exist.
The correlation data shown in the table highlights some of the diversification benefits an investor could realise from including inflation indexed bonds, other fixed income, and a variety of equity markets in their asset allocation process. Allocating significant portions of an investor’s overall portfolio to emerging markets, small-cap equities, and fixed income may feel uncomfortable for some, but the volatility reduction likely to result could significantly reduce the overall volatility of returns. In terms of some potential asset allocations, we outline three suggested allocations for investors willing to assume low, medium or high levels of portfolio volatility: Based upon our projections and assumptions these portfolios maximise expected returns relative to overall portfolio volatility.
US equity allocation is much lower than many conventional asset allocation plans would recommend, and the emerging markets allocation is much higher. This is driven by our return expectations as well as by the diversification impact of these two asset classes. The real estate allocation is based on a broadly diversified real estate portfolio. If this is not an option, this allocation should be reallocated into inflation-indexed bonds and the European and US equity categories in roughly equal proportions. For the low risk portfolio, very heavy allocations to inflation-indexed bonds and to conventional bonds are indicated. In all cases, overall portfolio return expectations for the next 10 years are modest.
Within European equities, we would favour a significant overweight in small-cap equities. Within US equities, there should be a slight tilt towards value stocks, based on our return forecasts.
John Chisholm is co-chief investment officer at Acadian Asset Management /Palladyne in Amsterdam
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