GREG VAN INWEGEN, GLOBAL HEAD OF QUANTITATIVE RESEARCH AND ASSET ALLOCATION, CITI INVESTMENT MANAGEMENT
Portfolio asset allocations must be revisited when the assumptions that drive them change, as they have in 2020. Our updated Strategic Return Estimates reflect new realities that long-term investors cannot ignore.
KEY MESSAGES
The monetary and fiscal response to the pandemic's fallout have profoundly impacted many asset classes’ future return potential
The monetary and fiscal measures to combat the global economic shutdown’s devastating effects have helped avert a second Great Depression. But these measures’ consequences have profoundly impacted many asset classes’ future return potential, especially fixed income and cash. We have therefore decided to update our annualized asset class return estimates for the next decade - Strategic Return Estimates (SREs) - at the mid-year stage, rather than waiting until our normal year-end review.
The changes in our SREs are material. They have risen for developed market equities, especially for small- and medium-sized equities – figure 1. High yield fixed income’s SRE has also risen along with that of emerging market debt. Changes like these are rare and have been instigated by large declines in expected returns from sovereign bonds and cash.
Based on SREs, our strategic asset allocation methodology – Adaptive Valuation Strategies (AVS) – recommends allocations to multiple asset classes. AVS tends to recommend larger allocations to asset classes with higher SREs. However, some asset classes with more modest SREs can provide valuable downside protection in stress environments and will also receive allocations.
The material recent SREs changes thus require some portfolio adjustment to reflect the changes. As such, our discretionary programs will undergo reallocations over the coming months.
*Preliminary SRE changes based on returns through 30 Apr 2020.
Source: Citi Private Bank Global Asset Allocation team. 2020 SREs based on data through 31 Oct 2019. Strategic return estimates are no guarantee of actual results. Past performance is not indicative of future results. See Glossary for definitions. Strategic Return Estimates (SRE) based on indices are Citi Private Bank’s forecast of returns for specific asset classes (to which the index belongs) over a 10-year time horizon. The forecast for each specific asset class is made using a proprietary methodology that is appropriate for that asset class. Equity asset classes utilize a proprietary forecasting methodology based on the assumption that equity valuations revert to their long-term trend over time. The methodology is built around specific valuation measures that require several stages of calculation. Assumptions on the projected growth of earnings and dividends are additionally applied to calculate the SRE of the equity asset class. Fixed Income asset class forecasts use a proprietary forecasting methodology that is based on current yield levels. Other asset classes utilize other specific forecasting methodologies.
Why so many changes?
US Cash’s SRE has dropped significantly this year, as the US Federal Reserve cut interest rates effectively to 0% in March.
In Global Developed Fixed Income, central bank asset buying is driving Government Bond SREs materially lower. SREs for Investment Grade (IG) Corporate’s SREs, however, are determined not only by changes in rates, but also by credit spreads. Since rates and credit spreads have pulled in opposite directions, the SRE is little changed. Combining Developed Government Bonds with Developed IG Corporate Bonds, the net effect is lower overall Developed IG Fixed Income SREs.
Conversely, High Yield Fixed Income’s (HY) SRE has increased. HY is heavily driven by its credit exposure, rather than rates sensitivity. Similar to Corporate IG, pandemic risks have widened HY’s spread significantly. Energy sector bonds have been especially hard hit.
Emerging Market Debt SREs have also increased. Asian debt market volatility has been muted relative to Latin American markets, which have been heavily punished by investors. This effect has pushed up overall EM Debt SREs.
Developed Market Equity’s SRE has risen. While cyclically-adjusted earnings have fallen somewhat amid the economic shutdown, current equity market prices are down by more. As result, the cyclically-adjusted price earnings ratio has dropped since year-end 2019, which boosts the SRE. Developed Small Cap Equity’s SREs has also increased. The turmoil has hit small-cap equities hard, given concerns about their less diversified revenues and greater distress risk.
Hedge Funds have characteristics of both equities and fixed income. As of mid-year, the latter component had been the more influential, with early 2020’s declining yields and interest rates lowering Hedge Fund SREs.
Paisan Limratanamongkol, Andy Zhu, Gene Desello, Xin He, and Wenjing Wu also contributed to this article
To read about more about our methodology, see Adaptive Valuation Strategies - A New Approach to Strategic Asset Allocation: 2020 Annual Update https://www.privatebank.citibank.com/home/fresh-insight/adaptive-valuation-strategies.html