Asset allocation themes for this year and beyond
- Though the tapering of quantitative easing and the decoupling of the US economy from the rest of the world argue for shifting away from bonds and international equities toward US equities, we think this temptation should be resisted.
- Our analysis has found that over the long run, valuation plays a much more important role in asset class performance than economic growth.
- We highlight the value of diversification by illustrating the perils of chasing performance and focusing on the short term.
- A diversified portfolio can also help to mitigate the risk of rising interest rates, especially but not exclusively in the fixed income allocation.
- With both stocks and bonds rich relative to historical averages, we highlight a few portfolio tilts that we believe may help improve risk-adjusted performance in a low-return environment.
Over the past couple of years, two popular economic stories have emerged. First, the tapering of asset purchases by the US Federal Reserve has created a challenging environment for the performance of bonds relative to stocks, as evidenced by yields rising roughly 1% and equities outpacing fixed income by more than 30%. Second, the US economy appears to have decoupled from the rest of the world, driven mainly by increasing energy independence and the revival of the US manufacturing sector.
Given these two themes, we might be tempted in the near term to sell bonds and use the proceeds to buy stocks, and to abandon a more diversified portfolio of global equities in favor of one that is more concentrated in US equities. As natural as these reactions seem, we believe it is important to stay disciplined and focused on the longer term. We take this opportunity to share some of our analysis that highlights the benefits of diversification in a balanced portfolio.
Stocks versus bonds
In early 2013, we considered equity to be more attractive than fixed income. Based on our long-term historical analysis, bond valuations were rich relative to their 50-year average by nearly two standard deviations, in the top 5% of valuations observed over the period. By comparison, stocks at that time were similar to their 50-year average. Since then, however, the yield on the 10-year US Treasury bond has risen by roughly 1% meaning that bonds have become cheaper and the S&P 500 has risen more than 30% making stocks more expensive. Stocks are now in the top 25% of rich valuations over the past 50 years, while bonds are in the top 10%.
This 50-year period has been notable for two characteristics that may influence the averages: cheap bond prices when interest rates were extremely high throughout much of the 1970s and 1980s, and very expensive stock prices during the technology bubble in the late 1990s. Interestingly, if we compare current prices with those over a longer history going back to the late 1800s, say stocks seem to be the asset class in the top 10% of observed valuations and bonds appear to be only in the top 25%.
Using more recent history as our guide, stocks are probably still a little more attractive than bonds though the misalignment between the two asset classes is not as clear as it appeared to be last year, and both are somewhat expensive relative to historical valuations over longer time periods. We would be cautious before abandoning a balanced portfolio containing both stocks and bonds for one that is more equity-heavy. From a valuation perspective, we might consider holding a little more cash than usual in the near term and waiting for better opportunities to buy both asset classes in the future.
Economic growth and equity performance
While it is plausible that the United States may be decoupling from the rest of the world, we think the question is not whether US economic growth will be stronger but rather, do better economic prospects lead to better performance of the US stock market? It seems reasonable that GDP growth and equity performance should be related. After studying over 100 years of data, however, we could identify at best only a very weak relationship.
We also looked at the relationship between GDP growth and equity market performance across different countries over the 60-year period from 1950 to 2010. We found that on a decade-by-decade basis, the equities of countries ranked in the top half of GDP growth outperformed those in the bottom half by less than 0.5 percentage point per year. So even if we could identify with perfect foresight which countries would grow the fastest each decade, the return advantage would not be enough to justify focusing on those and forsaking all others.
Equity valuations by market
Unlike economic growth, valuation does seem to matter in the long run. And we find that many of the countries with GDP growth concerns including parts of Europe and some emerging markets are the ones with the most attractive valuations (see Exhibit 1).
Some valuation measures suggest that the US market is fairly priced, but most of these multiples are reasonable only if we expect corporate profit margins to remain elevated at 50% to 100% above their long-term averages. Profit margins among developed countries excluding the United States, on the other hand, have been running close to historical norms (see Exhibit 2).
Based on an analysis of data across more than 20 countries, we have found that abnormally high or low profit margins are not sustainable but are reliably mean reverting. Assuming that margins revert back to their historical averages, our proprietary valuation method indicates that US equities are rich. According to other valuation measures that are also less reliant on margins remaining elevated including the ratio of market capitalization to GDP, the Shiller P/E comparing the current price to 10 years of inflation-adjusted earnings and Tobins Q comparing equity market value to replacement value the US equity market is materially overvalued.
The potential overvaluation of US equities makes it especially critical now to maintain a globally diversified portfolio, including more fairly priced asset classes. Lets review a few of the other ways to take advantage of diversification in a balanced portfolio.
VALUE OF DIVERSIFICATION
Avoiding performance chasing
What can happen when we abandon a more diversified approach to chase the high-performing asset classes of the recent past? To illustrate, we compared a hypothetical portfolio of risky asset classes that have exhibited the best returns over the previous five years with another hypothetical portfolio that simply buys and holds risky assets in equal weights, rebalanced monthly (see Exhibit 3).3
Relative to the performance-chasing portfolio, the diversified portfolio winds up with a 37% higher cumulative return, 12% lower risk, a significantly smaller drawdown during the global financial crisis of 2008 2009 and much lower turnover. In fact, the return differential may be understated because this illustration ignores transactions costs, which will be higher for the performance-chasing strategy and lower for the diversified strategy. In general, tactical tilts may be able to improve performance if made carefully. But this example illustrates
the dangers of tilting a portfolio to follow performance.
Focusing on the long run during a short-term crisis
We would like to address a common argument that diversification failed during the global financial crisis. Because risky assets all behaved similarly from September 2008 to March 2009, holding a diversified portfolio of these assets would have provided practically no protection. The only assets that were able to cushion the downside were US Treasury bonds and cash a further argument against abandoning the bond holdings in a balanced portfolio.
During the flight to quality typical of such severe market downturns, how a portfolio performs in the short run may be affected more by what percentage it holds in risky assets than by how it is allocated among those assets. So the benefit that diversifying across risky assets provides is not protection against the short-term impact of market crashes but rather, the performance of a diversified portfolio over the long run. As the investment horizon is lengthened, performance can vary dramatically from one asset to another. We have found this to be true even if the investment horizon contains a period in which all risky assets fall by similar amounts at the same time.
For example, six risky asset classes may have behaved nearly identically during the September 2008 meltdown, but they have experienced dramatically different results over a longer period starting in January 2000 (see Exhibit 4).4 A portfolio of US large growth stocks would have barely broken even, failing to keep pace with the rate of inflation at over 2% per year during this period, whereas a portfolio of REITs would have experienced a cumulative return of more than 350%!
It is difficult to know with certainty which asset class will exhibit the best returns in the long run. But investing in a broadly diversified portfolio of different risky assets removes the chance of unluckily picking the one or two asset classes with the worst performance. This is something to keep in mind when we think about abandoning a globally diverse portfolio to buy US equities in the current environment.
Managing interest rate risk
Interest rates have increased considerably off their lows in 2012, yet they are still quite low by historical standards. A further rise is a potential risk for fixed income investments, yet rising rates do not impact all bondholders equally.
To illustrate this, we grouped the average monthly returns for a subset of different types of bonds and other assets by monthly interest rate changes since 1980, with quintile 1 representing the largest declines and quintile 5 representing the largest increases (see Exhibit 5).5 Clearly, the response to interest rate changes varies by asset class.
The primary measure of how a bond will respond to a change in interest rates is known as its duration, which is closely linked to its maturity. The US government bond index, for example, shows relatively strong performance when interest rates fall (quintile 1), and poor performance when they rise (quintile 5). The response is more severe for the US long-term government bond index, which has the longest duration, and less severe for the US short-term government bond index, which has the shortest duration.
A secondary consideration in a bonds response to rising rates is its credit status. Corporate bonds have typically performed a little better than government bonds of a comparable duration when interest rates go up, because the extra yield on corporate bonds can provide a little extra cushion.
US high-yield bonds are an extreme example of bonds that have more credit exposure and less interest rate exposure. As a result, high-yield bonds have historically behaved more like equities and exhibited much less sensitivity to interest rate changes, although both high-yield bonds and equities have seen their worst performance during periods of rising rates. By contrast with bonds, commodities have performed poorly when interest rates were falling but fared relatively well when interest rates were rising.
When rising rates are a concern, we would consider increasing our allocation to shorter-term bonds, which tend to exhibit less sensitivity to interest rates than longer-term bonds. Credit exposure can also serve to further dampen interest rate sensitivity, but we would exercise caution when investing in high-yield and high-grade corporate bonds given their strong recent performance and link to the equity market.
Even with a balanced portfolio of stocks and bonds, a rise in interest rates could lead to subpar equity performance as well as poor fixed income returns. Allocations to commodities which have historically exhibited similar risk and return profiles and low correlations relative to equities, as well as negative correlations with bonds may help to hedge against this risk.
Asset allocation guidelines and long-term alpha
We conclude by returning to a fundamental question of asset allocation, namely the comparison of stocks and bonds. With interest rates still so low by historical standards, fixed income is potentially overvalued. In addition, low interest rates for a long period of time have led to stretched valuations in other asset classes such as equity and credit. So we believe a balanced portfolio of stocks and bonds can probably be expected to generate lower returns than such a portfolio would have delivered historically.
Taking valuation and the economic environment into account, we think the alpha or return over the benchmark that can be added through active management will probably be more important than it has been historically. For example, an extra 100 basis points of return represents a much higher percentage of expected total return at 4% 5% than at 8% 9%.
In this kind of environment, we would think about making a few sensible tilts to take advantage of investment opportunities that may help to improve risk-adjusted performance. Note that these suggestions are based largely on the valuation component of our quantitative process. While valuation works well in the long run, patience may be required over the periods when valuation does not work as an investment signal.
- Exercise caution overall. With the possibility that both stocks and bonds may be overvalued, we would expect to hold a little more cash than usual.
- Avoid taking excessive duration risk. At such low interest rates, bond investors are probably not being compensated for the risk of rising rates.
- Exercise caution with high-yield and high-grade bonds. We may not be seeing asset quality issues, but with discount rates and credit spreads so low, high-yield and high-grade valuations appear stretched. This suggests that bond investors are not being compensated for credit risk.
- Exercise caution with respect to US equities. The United States has enjoyed stronger performance relative to most other markets, leaving US stocks looking expensive by historical standards.
- Avoid emphasizing small-cap over large-cap equities. Within the US equity market, small caps have had the strongest performance and look the most stretched from a valuation perspective. For context, when small caps were more expensive than large caps in the early 1980s, large
caps outperformed small caps by 6% annually over the subsequent decade, and the valuation gap between small caps and large caps is even greater now.
- Consider non-US and emerging market equities. This may be challenging given the lingering economic problems in some emerging countries, but from a valuation perspective, we believe stocks in these markets appear priced to deliver returns that are more in line with their historical averages.
Of course, no investment strategy including asset allocation can guarantee a profit or protect against a loss. But these steps may help to make the most of a low-return environment. And we always advocate the importance of investing over a longer time horizon, establishing a broadly diversified portfolio and rebalancing regularly as the cornerstone of a disciplined investment process, and working with skilled managers who have demonstrated the ability to add alpha through superior security selection in stock and bond markets.
1 Relative valuation based on Datastream Market Price/Earnings Ratio (Adjusted), Price to Book Value, Dividend Yield and Price/Cash Earnings Ratio for US
2 Datastream Market Net Profit Margin for US and developed world excluding US represented by Australia, Canada, France, Germany, Hong Kong, Italy, Japan, Netherlands, New Zealand, Norway, Singapore, Spain, Sweden, Switzerland, UK.
3 Risky asset classes represented by US large cap Standard & Poors 500 Composite Datastream Calculated Total Return Index, US large growth MSCI US Large Cap Growth Total Return Index, US large value MSCI US Large Cap Value Total Return Index, US small cap Standard & Poors 600 Small Cap Datastream Calculated Total Return Index, US small growth MSCI US Small Cap Growth Index, US small value MSCI US Small Cap Value Index, US REITs FTSE/NAREIT All REITS USD Total Return Index, non-US equities World ex US Datastream Market Total Return Index, non-US small cap MSCI All Country World ex US Small Cap Unadjusted USD Total Return Index, EM equities MSCI Emerging Markets Unadjusted USD Total Return Index, US high-yield bonds US Corporate High Yield Total Return Index.
4 Risky asset classes represented by US large growth MSCI US Large Cap Growth Total Return Index, US large value MSCI US Large Cap Value Total Return Index, US small cap Standard & Poors 600 Small Cap Datastream Calculated Total Return Index, US REITs FTSE/NAREIT All REITS USD Total Return Index, non-US equities World ex US Datastream Market Total Return Index, EM equities MSCI Emerging Markets Unadjusted USD Total Return Index.
5 Asset classes represented by US government bonds Barclays US Aggregate Government Total Return Index, US long-term government bonds US Government Long Term Total Return Index, US short-term government bonds US Government 13 Year Total Return Index, US high-yield bonds US Corporate High Yield Total Return Index, US large-cap equities Standard & Poors 500 Composite Datastream Calculated Total Return Index, Commodities Standard & Poors Goldman Sachs Commodity Index (GSCI) Total Return.
MFS Quantitative Solutions Multi-Asset team members contributed to this analysis.
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