Sellwood’s August 2020 Market Snapshot is available for download.
Second Quarter 2020: Federal Intervention Masks Underlying Economic Uncertainty
Rising Covid-19 cases, mass unemployment, and stop-start reopenings have hurled uncertainty at the markets and yet, the S&P is down only 3% for the year-to-date ended June 30th. The second quarter rally, with the S&P rebounding 20%, has notably amplified one familiar market trend of the recent past, growth’s continued dominance over value. Whatever your preferred alphabet soup acronym for Facebook, Apple, Amazon, Netflix, Google, and Microsoft, the tech-heavy giants have been the comfort food for investors in the Coronavirus world, pushing the Russell 1000 Growth up a remarkable 10% for the year. U.S. value stocks, as measured using French and Fama data, are in their longest and second sharpest relative drawdown since 1933. Similarly, any portfolio tilts away from the large American tech giants and towards small-cap or international markets have hurt relative performance for the quarter and year. Broad international markets are down approximately 11% for the year while the Russell 2000 is down 13%.
Easing financial conditions in the second quarter helped risky bonds rally as the market responded to the promise of support from the Federal Reserve and Congress. Investment-grade US companies are currently able to raise debt at all-time low yields and many did just that, as new bond issuance hit record levels during the quarter. Yields on safe U.S. Treasury bonds were largely unchanged or slightly down for the quarter, reflecting expectations for a low-growth, low-inflation world in the immediate term. Interestingly, despite the record stimulus, market expectations for inflation remain well below the Federal Reserve’s stated 2% target.
Like always, what is in store for markets the rest of the year is anybody’s best guess, especially with the U.S. entering into election season and governors left grappling with budget holes and rapidly increasing Covid-19 case counts.
Every year, we update our forward-looking Capital Market Assumptions – the building blocks of our asset allocation work on behalf of Sellwood clients – as of December 31. Because equity and bond markets have changed so considerably in the first quarter of this year, we have taken the extraordinary step of updating those assumptions outside our normal calendar. With this update, our asset allocation work for clients will reflect market data as of March 31, 2020.
In the first quarter of 2020, equity values plunged, credit spreads widened, and Treasury bond yields declined substantially. The US stock market registered its fastest 30% decline in history while US corporate bonds lost 7% in March. US Treasury bonds were one of the few investments that provided a positive return as yields fell below 1% across the entire yield curve. Inflation expectations for the next ten years were roughly cut in half, as market participants began to process the likelihood of a looming recession. We believe that these dramatic first-quarter market movements have improved return prospects for public equities by about 0.5% per year over the coming decade, and reduced return prospects for investment-grade bonds by about 0.5% to 1.5% per year over the same horizon.
As stock and bond prices changed in the first quarter, their valuations – which inform future returns – changed as well. The following chart depicts a signature valuation metric for several major asset classes. The blue boxes represent quartiles of each valuation metric’s own history, and the arrow represents the change in that valuation metric from December 31, 2019, to March 31, 2020:
In the first quarter, equities and riskier bonds (corporate and high-yield issues) became substantially cheaper and US Treasury bonds became more expensive. As market participants grappled with an unfolding pandemic and processed its implications for the economy, investment safety became more expensive and risk-taking became more rewarding.
Translated into forward-looking assumptions, recent market changes reveal some interesting opportunities. The following chart depicts the real (after-inflation) changes to our annualized 10-year, forward-looking assumptions for compound return. We assume that the prospective return for long-duration Treasury bonds declined, but every other asset class improved:
If inflation expectations did not change, the recent market decline would also have resulted in higher nominal (before-inflation) expected returns nearly every asset class. Higher recession probabilities, however, caused inflation expectations to decline along with risky assets. Our process incorporates future inflation expectations to derive the “headline” nominal compound return assumption. After taking lower inflation expectations into account, we expect that changing markets in the first quarter reduced future bond returns by between 0.6% and 1.4%, and increased equity returns by about 0.4% to 0.5%.
Forecasting higher equity returns, and lower cash returns, means that we are forecasting a higher equity risk premium than we did at the end of the year. The equity risk premium represents expected future compensation for taking the investment risk of owning stocks, relative to owning riskless cash. Prior to the first quarter of 2020 unfolding, we forecasted nearly the lowest equity risk premium since 2012. Stock markets were priced for nearly everything to go right. After the first quarter, when almost nothing went right, we now estimate that the premium has increased by nearly one percentage point a year for the coming decade. While falling short of representing a generational opportunity, we note that stocks are priced to deliver meaningfully better returns, relative to other opportunities, than they were just three months ago. (As a reference point, our methodology would have forecast an equity risk premium of just 2.0% in December 2007, and 6.7% in December 2008.)
- The first quarter’s market movements were substantial enough, in our view, to meaningfully alter the prospects for investment return over the full coming decade. Accordingly, we have revisited and updated our prospective 10-year Capital Market Assumptions to reflect the new information the market has given us.
- Lower yields for US Treasury bonds reflect an unprecedented premium on safety and have reduced prospects for their future return.
- Future returns for high-quality fixed income outside of US Treasury bonds have benefited from lower valuations on a real (inflation-adjusted) basis, but lower inflation expectations result in lower nominal expected returns.
- Lower valuations for risky assets like global stocks provide support for higher future return.
- Compensation for taking investment risk has increased. Risk is positioned to be more richly rewarded over the coming decade than it was a quarter ago.
- Non-Core fixed income, which we define as below-investment-grade and emerging markets bonds, may present a meaningful, if fleeting, opportunity for return enhancement. US High-yield spreads rose sharply not only in response to the global pandemic, but also in response to an oil price war between Russia and Saudi Arabia.
First Quarter 2020: The End of the Bull Market
The longest bull market in U.S. history peaked in February before swiftly falling into bear market territory, as COVID-19’s impact, along with an oil price war, were felt across the globe. In what is never a good sign of the times, market observers were forced to reference the Great Depression and 2008 global financial crisis in order to find comparisons not only for the market volatility, but also for the swiftness of the decline. The S&P 500 Index declined 34% between its all-time high on February 19th and the quarter’s low, set 33 days later on March 23rd. All in, the S&P 500 ended down almost 20% for the quarter, the sixth-largest quarterly decline since 1927 and the worst since 2008.
Market volatility was persistent during the asset sell-off as investors sold anything with a hint of risk once it became clear that the global economy would be skidding to an unprecedented hard stop for the immediate future. The Federal Reserve moved quickly to provide liquidity and funding support, dusting off a wide range of tools last seen during the tumultuous days during the 2008 financial crisis. Congress acted as well, passing a $2.2 trillion dollar rescue package – nearly three times as large as 2008’s – in the final days of March.
Against this backdrop, bonds either protected or disappointed, depending on their day-to-day liquidity and credit quality. US Treasury yields fell to historic lows as investors sought the safety of US Treasury bonds, which rose by more than 8%. Long bonds, most sensitive to rate changes, performed the best. Anything with risk, meanwhile, declined: high-quality corporate bonds declined by nearly 4%, and high-yield and emerging markets bonds, among the riskiest sectors of the bond market, declined by 13-14%.
Sellwood Consulting’s 2020 Capital Market Assumptions contemplate a prospective lower-return environment caused by last year’s extraordinary valuation expansion in nearly every asset category.
These 10-year, forward-looking assumptions of asset class return, risk, and correlation are the key input variables for our asset allocation work on behalf of clients.
2019 Was Extraordinary but Borrowed from the Future
Over the course of 2019, every major asset class became more expensive. Expensive equities became more expensive, and low-yielding bonds saw their yields decline. Most of the extraordinary returns that we witnessed in 2019 borrowed from future return, and our forward-looking assumptions declined accordingly.
We can consider one example: U.S. large company stocks. In 2019, the S&P 500 returned 31%. Less than 3% of that return came from dividends. Underlying earnings stayed flat for the year, contributing less than 1% to total returns, as corporate performance stagnated. Over 90% of the index’s return – 28% — came from simple multiple expansion, reflecting the fact that investors were willing to pay 1/3 more for a dollar of future earnings at the end of the year than they were at the beginning of the year. (This effect was especially pronounced for growth stocks, where cash flows are further into the future, as the Federal Reserve reduced discount rates and made those future cash flows more valuable in the present day.)
Over the long-term, stock returns are driven by earnings growth, which is either reinvested or returned to shareholders in the form of dividend payments. When asset prices go up because of valuation expansion, as opposed to fundamental growth in the underlying asset, these prices borrow from future return.
Long-term equity valuations are higher today than they have been at any time in history, with the notable exception of the 2000-2002 equity market bubble. Our process soberly assumes that valuations will not remain at these elevated levels, reverting instead toward a long-term average. In the case of U.S. Equities, this analysis subtracts nearly three percentage points from our assumed future annual return over the next decade — or about 30% in total. Essentially, in the case of U.S. Equities, we assume that 2019’s equity market revaluation is reversed over the next decade. Over the long term, it may very well be the case that higher valuations are warranted. But if all of that repricing occurs in a single year, by definition it cannot happen again. We don’t know what the market’s valuation multiple will be in 10 years. But whatever it is, higher valuations today present a shallower path of return from here to there.
Bonds are a simpler story, but our analysis is similar. Like with equities, we assume bond valuations — real yields — will revert toward a historic norm over the coming decade. This analysis implies that 2019’s stellar performance for bonds, which was entirely based on yields falling, will be partially reversed in the next decade. In the simplest possible terms, when bond yields decline, an investor experiences future potential return accelerated into the present. The lower yield you end up with implies that returns will be lower in the future – they must be, because you have already experienced part of your total return. Owning a bond (or bond portfolio) as yields decline means, quite literally, that you have pulled return from the future into the present — borrowed from future return.
This is not a bad problem to have, if you own the asset — who wouldn’t want their cake sooner? It only presents a challenge for allocating portfolios for the future. Our 2020 assumptions acknowledge 2019’s extraordinary market returns by presenting a rather dismal forecast of the next decade:
Last Year: Right Direction, Wrong Horizon
It may be worth noting that when we developed Sellwood’s 2019 Capital Market Assumptions a year ago, we painted a much rosier picture. Following a dismal year for stocks and bonds, we stated, “we believe that over the next ten years, investors will receive more compensation for taking risk than they were poised to a year ago. In the case of fixed income, higher real yields bring greater opportunity for return with lower risk. For risky assets, like global equities, the market experience of 2018 brought lower valuations, which increase the potential for future return.” Our analysis proved correct — but the entire benefit that we forecasted over the next decade happened to occur in the first year of the forecast period.
As a result of these updates, our 2020 forecasted “capital markets line,” depicting opportunities for investment return at varying levels of risk, has declined. It is perhaps interesting that the line has not flattened — generally speaking, after a 30% year for stocks, their expected return would decline, flattening the line. But today, following extraordinary returns for both stocks and bonds, the entire line has shifted down in parallel (from the dotted line to the tan line):
The height of the capital markets line determines the level of return that an investor can expect, over the long term, by investing in various combinations of assets. Over the last year, higher valuations in every asset class have pushed this line downward. Investors should expect lower returns from today’s starting point than from the more generous starting point that markets offered a year ago.
The slope of the capital markets line determines how much an investor can expect to be compensated for taking risk. That the slope of the capital markets line hasn’t meaningfully changed this year suggests that market movements in 2019 did not present any meaningful new relative opportunities between asset classes.
Where does all this leave us? With an uninspiring set of market opportunities. At minimum, we suggest that investors should be careful about extrapolating past returns – especially recent past returns – into the future. If those returns have borrowed from the future, they won’t be repeated.
Investors with fixed liabilities that require a specific investment return (e.g., many endowments, foundations, and underfunded pensions) face a very difficult asset allocation environment. Lower return opportunities in capital markets coupled with fixed return objectives imply that more portfolio risk must be taken to achieve the fixed return objective. Increasing risk at a time when valuations are high leaves little room for error.
Markets today aren’t offering many places to hide, but investors’ unique circumstances might. If we can offer any solace to the dim outlook we have presented, it is to suggest that long-term investors can take refuge in those long-term horizons. Investors that are truly structured for the long term can still reasonably expect that equity risk will be rewarded, that bonds will diversify their portfolios, and that reasonable liabilities can be met with investment return.
Even after this year’s changes, we still forecast annualized compound returns of 4.5-5.5% for most diversified portfolios, over the coming decade. The future won’t repeat the past, but it will still probably be all right.