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Recasting portfolios for late-cycle shifts

Navigating late cycle doesn't mean avoiding risk, but it does mean knowing the risks being taken


JP Morgan Asset Management publishes a set of projections in an annual report, the Long Term Capital Market Assumptions, which looks into 50 asset classes and how they would perform over the next 10 to 15 years. Genevieve Cua speaks to Hannah Anderson, the firm's global market strategist, on the findings and implications of the 2019 report.

What does the latest research - the Long Term Capital Market Assumptions 2019 - say about where we are in the economic cycle, and the implications for major asset classes?

Our research gives risk and return projections over 10 to 15 years, because strategically minded investors need some type of market-return forecast to craft a financial plan, or if they're an institution, to formulate a long-term asset allocation strategy.

Without a view on how stocks, bonds and other asset classes are apt to perform, it's hard to know how much you'll need to save and for how long, or indeed, how to invest. Our assumptions help investors arrive at an educated guess of how much markets will contribute to the success of their plans and form a better understanding of the themes that have implications for portfolios.

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All evidence in this year's Long Term Capital Market Assumptions points to a US business cycle that is in its later stages, meaning the economic expansion is maturing and the risk of recession, while not imminent, is rising.

We expect to see continued flattening in the horizon of the additional return gained from adding risk to a portfolio. Typically, this portfolio frontier - or the line you could draw of the return offered by a portfolio and the volatility associated with that portfolio from an asset mix that is 100 per cent bonds to one that is 100 per cent equities - is relatively steep since equities, while more volatile, traditionally offer substantially higher returns.

Improved return assumptions for US fixed income versus last year, but relatively unchanged assumptions for global equities, means this frontier is flatter than assumed last year.

Overall, we expect more modest returns in the future from developed markets because asset prices have already run up considerably. The sell-off in markets at the end of 2018 did move equity valuations closer to where we think their long run equilibriums are, removing a bit of the drag on long run returns from our estimates based on data as at Sept 30, 2018.

There is also greater divergence between regions, both in terms of asset returns and in business cycle position, than in prior years, implying the need for greater selectivity in portfolios and that regional diversification benefits may have improved. The somewhat improved return expectations for alternative strategies - across financial and real assets - are a relative bright spot as our assumptions are relatively attractive on a risk-adjusted basis.

One of the messages of the research is to "manage outside the mean". What does this mean, and how does it translate for long-term retirement portfolios?

Managing outside the mean implies that investors may need to adjust their expectations for what a "return to normal" may look like, into and through the next end of cycle. Mean-reversion assumptions underpin many asset classes return forecasts, meaning that investors traditionally assume asset classes will return something close to their historical levels and be valued similar to the way they have in prior cycles.

It's a powerful idea that underpins some approaches to investing and it makes sense that returns can be more extreme in the short run but more stable and reflective of their own averages in the long run.

However, given the structural shifts in global asset markets over the past decade, notably the advent of measures by central banks designed to stimulate the economy and increase liquidity, and the long-run progression of economic trends - ageing populations and modest productivity growth - we may need to start thinking that what we have defined as "extraordinarily" low returns or "high" valuations or "unusual" monetary policy are, in fact, now the norm for markets.

Long-term investors need to realise that risks in a traditional mean-variance framework might not be captured or compensated going forward. Policy rates seem the most obvious example of where things may not return to their historical norms, as flatter cycles less sensitive to stimulus, lower potential growth and more aggressive central banks all hold policy rates below their long-run averages for extended periods.

This could in turn stoke asset prices, driving future rounds of asset inflation without associated price inflation. New technology trends only serve to further contain price and wage inflation, even as they boost real growth and productivity. To the extent that such an environment reinforces economic inequality, the temptation for governments to borrow to fund fiscal stimulus is a good reason to think that national debt levels are unlikely to mean-revert anytime soon.

In our view, policy rates, government balance sheets, market structure patterns and inflation trends all represent structural shifts in the investing environment that a simple mean-reversion framework is unlikely to capture. To help meet these challenges, investors could focus on more active investment in secular themes such as technology, and the growth in alternative assets, as well as ensuring they are appropriately compensated for all elements of risk - not merely market risk. Navigating late cycle doesn't mean avoiding risk, but it does mean knowing the risks being taken.

What secular exposures or themes will serve investors well over the long term in terms of enhancing returns and mitigating risk?

The starting point in the business cycle matters a great deal for portfolios as investors need to be wary of some of the challenges presented by the behaviour of asset classes throughout the end of a business cycle, particularly liquidity risk. An attractive return over ten years from a higher allocation to private equity or high-yielding credit is not all that attractive if illiquidity during a market downturn forces an exit from those strategies at a loss.

The increasing need to be cycle-aware and to use a variety of tools to assess the risks associated with different asset classes are important themes explored in our research that should inform the way investors think about constructing portfolios. Investors will also want to consider themes extending beyond one market, like the globalisation of private equity opportunities or a potential productivity boost arising from the integration of technology into business operations across sectors.

Based on the latest study, what findings warrant a portfolio adjustment?

For the first time in many years, US fixed income offers a positive return in real terms. Sharpe ratios (meaning measures that help investors understand the return of an investment compared to its risk) for bonds have moved ahead of equities for the long run in US dollar assets. Outside the US, asset class returns paint a very different picture. For Singapore investors, paying increasing attention to currency exposure and being aware that normalisation in rates ex-US may be hampered by the current state of the business cycle - in that the global business cycle may roll over before central banks outside the US have tightened policy materially - should be key aspects of investment decisions over the next 10-15 years.

Perhaps most importantly, risk assets may offer attractive returns over the long run, but successful investing across cycles will require consideration of risks on a variety of metrics. W