This excerpt, taken from Balentine’s 2016 Capital Markets Forecast, discusses key themes we see over the next market cycle using today’s starting point. For the full article as written in our Capital Markets Forecast, please click here.
As we enter 2016, we are almost seven years into a domestic equity bull market run that has defied many investors’ expectations in both duration and magnitude. This equity market strength has brought forward years’ worth of returns. As a result, today’s landscape offers few markets priced for compelling opportunities. Successfully navigating these compelling options will necessitate more discernment in the absence of uniformly accommodative central bank easing. In other words, it is no longer enough for investors to be in the right neighborhood; rather, investors will have to be on the right street in the right neighborhood and perhaps even the right house on the right street in the right neighborhood.
It is under this context that we introduce our key themes for 2016:
- Low interest rates are likely to persist for longer than the market is currently pricing.
- We now anticipate a slower trajectory for interest rate increases. This will dampen bond returns versus our prior expectations.
- Projected equity market returns remain paltry, with slightly improved international returns offsetting weaker domestic returns.
- The risks and meager projected returns for public markets underscore the importance of Manager Skill and Private Capital.
Low interest rates are likely to persist for longer than the market is currently pricing.
This will constrain public market returns looking forward. Though the Federal Reserve action lifted the Fed Funds Rate in December for the first time in almost 10 years, we expect short-term and long-term interest rates to remain low for years to come. Turns in the interest rate cycle are typically a very long process. When the Federal Reserve began lifting short-term rates in 1951, the US 10-year rate was under 2.5%. Yet it took nearly seven years for the 10-year rate to break over 3.0%. Despite historical precedent that long-term yields will languish for a while, economists continue to predict a relatively quick ascension.
We now expect a slower trajectory for interest rate increases.
Though the Federal Reserve did follow through on its intent to raise interest rates in December, we are not confident it will match the “dot plot” of projected quarterly 25 basis point increases over the next year. Since there is compelling evidence that the current natural interest rate is close to zero, we find it unlikely the Federal Reserve will deviate too far from this threshold. Secondly, the Fed may be underestimating the impact of the initial rate hike on the wave of deflation we have seen to date, as exhibited by the action in the global commodity complex. In the face of additional interest rate hikes, deflation may actually exacerbate rather than improve, causing the Federal Reserve to slow down the pace of rate hikes. Janet Yellen has already signaled a potential course correction from the original trajectory earlier in February in light of weakening economic data points.
While a quicker liftoff trajectory would make for higher projected bond returns, an extended interest rate timeline also means increased reinvestment risk. Though we expect Safe to continue to be a shock absorber during sudden equity market volatility, it may be less so going forward.
Projected equity market returns remain paltry.
We look to international markets for a greater contribution to the success of our Market Risk building block, as we did in our 2015 Capital Markets Forecast. Two notable shifts during the past year further favor our forecast for international equities: 1) real US dividend growth is now projected to be at 1.9% versus 2.1% a year ago and 2) the valuation adjustment of international equities is now expected to be higher at 2.0% versus 1.6% in 2015. Moreover, we see the international opportunity set as more selective than we did in 2015. While we expect more overall out of international equities, it will be even more of a challenge to make sure we are invested in the right spots. As a result, we may need to increase our Art-based implementations in order to generate more alpha in the building block, as we did with our Japan allocation throughout 2015. Structural reform continues to play a key role, and regions like Japan that are making genuine attempts to reform government, regulation, and corporate governance are poised to grow and capture market share when the world economy turns a corner. Those who do not, notably the peripheral European countries, likely will be left behind.
The risks and meager projected returns for public markets underscore the importance of both Manager Skill and Private Capital.
Risks to valuations (in both fixed income and equity markets) and projected dividend growth (in equity markets) make for challenging returns looking forward. The starting valuation of an asset is a large predictor of the asset’s future returns. Because current equity valuations are so stretched, forward-looking returns in public markets are likely to be muted. Historically, equities and bonds have had an inverse relationship, meaning when one asset class was up, the other was down. While real yields on equities and bonds in isolation have been lower than they are currently, this inverse relationship allowed for an investment alternative between the two. Now, however, we are in relatively unprecedented times.
Putting together the equity and bond real yields into a traditional 60/40 portfolio, the joint expected return is lower than it has been at any time since January 1900. Thus, the ability for strategies to achieve their objectives absent contributions from Manager Skill and Private Capital is more challenging that it has been in the past.
Low-return environments often lead investors down a dangerous path of “chasing yield” without proper knowledge of the risks involved. This can lead to permanent impairment of capital. Investors must take intentional risk in unconventional ways to boost income and returns while paying careful attention to the risks involved. To bridge this gap, Balentine’s Investment Strategy Team has researched creative investment solutions within the Manager Skill building block (such as reinsurance and direct lending) which are designed to achieve the required results under appropriate levels of risk.
The Private Capital building block is perhaps a larger factor now than in the past, as concerns abound regarding dwindling expected returns in public markets. To that point, we have structured Private Capital among private equity and real assets that capitalize on both the illiquidity premium and on proactive, calculated risks that provide strong diversification and a more compelling risk-reward tradeoff. These assets can exhibit sharp drawdowns, and investors need to be prepared to use those drawdowns to their advantage, adding to these investments during times of distress, not liquidating them.
Click here to download the full 2016 Capital Markets Forecast and see how these key themes have helped define Objectives for client portfolios and the risk/return profiles for each.