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Forecasts and Expected Returns

SUMMARY

Forecast and Expected Returns

- Long-term trends: growth vs stagnation, megatrends, geopolitics and public debts... the main structural themes

- Expected Returns – short term and long term perspectives

 

 

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December 2017

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Decembre 2017

Forecast and Expected Returns

Prévisions et
"expected returns"

Long-term trends: growth vs stagnation, megatrends, geopolitics and public debts... the main structural themes

In the foregoing pages we have developed our scenarios for 2018 and beyond, as well as the investment themes, the risk factors, and the strategies implemented in the different portfolios. All this is based on convictions, forecasts, valuations of assets, potential impacts of various risk factors and therefore risk allocations. But beyond the forecasts and scenarios for the next two or three years, there are other crucial questions, in the longer term this time. The answer to these questions determines the 10-year views in the forecast and expected returns tables.

Q1 / Have we really entered an age of secular stagnation (or even secular deflation)?

This is a crucial question because if this is the case, not only would the current improvement in overall growth be small, but it would also be unsustainable. The factors that lead to secular stagnation are now well known: (i) demographics and aging of the population, (ii) the decline in productivity gains, (iii) the rising and cleaving cost of education, (iv) the burden of the debt (public and private) and deleveraging that constrain pro-cyclical policies (fiscal and tax policies in particular); v) monetary policies (whose efficiency is reduced and room for manoeuvre is now non-existent), vi ) globalisation (which pushes down real wages in particular). A simple way to calculate potential growth is to take into account the evolution of the labour force (the population of working age) and productivity gains. It is easy to see the generalised decline in potential growth, which is more pronounced in some countries because of demography (China, for example, growing old before being rich), and in others because of declining productivity gains (United States).

It is a simple method, but the results are at present uncertain, especially because of the productivity component. Several “schools” clash: some authors consider that it is not possible to measure this indicator correctly; others believe that gaps between companies, sectors, regions and countries are confusing the overall message; others argue that the
implementation of new technologies takes time, and that the impact will be visible in only a few years; others argue that the first phase of innovation translates into “creative destruction” in the long term, while others believe that the effects of the Third Industrial Revolution linked to NICTs (New Information Technologies and Communication), which began in the 1960s, would be (already) completed. Overall, potential growth calculations are unreliable because they are too dependent on a debatable component. Reasoning in terms of potential growth seems risky.

We must qualify all that. Not only do the factors of stagnation / deflation not all have the same scope, but they do not apply to all countries either. Some are very present, others less crucial now. Others can be corrected by economic policy actions. Overall, it seems reasonable to bet on improving productivity conditions, but given the weight of some of the structural factors discussed above, long-term growth is not expected to increase significantly, though.

Q2 / What are the many factors that underlie secular stagnation, those that are sustainable, and those that are not?

Answering this question makes it possible to better specify the countries or areas in danger of secular stagnation, and those that may eventually be able to overcome them for a long time. The table below shows the state of the debate and our convictions.

In total, fears of secular stagnation are more legitimate in advanced countries than in emerging countries (excluding China) and developing countries1. But some structural factors are not inevitable: corrective measures are still possible.

Q3 / How can an investor manage the low interest rate environment and fears of secular stagnation? What do megatrends bring to long-term investors?

Megatrends are structural changes that impact society, the economy, politics, our everyday lives. They represent breaks, “disruptions”, and therefore investment opportunities. They have three major characteristics: (i) large-scale effects, (ii) long-lasting effects, and (iii) global effects. Megatrends can be grouped under four headings: i) demographics, ii) technology, iii) the environment, and iv) social, behavioural, ethical values.

Investing in megatrends presents several advantages in the current environment: it is a good way to invest in future “winners”, to get out of benchmarks (representing past winners), to get out of the themes of secular stagnation (low growth, low interest rate environment) and to better expose to secular growth, reducing exposure to purely
cyclical factors and benefiting from thematic approaches. It is also a good way to find a better risk / reward ratio, and invest where the risk is still paid.

Tableau1

Q4 / How do you eventually get out of debt accumulation situations?

The level of indebtedness continues to be a problem because of the constraints on economic policies, but also because the real deleveraging is still yet to come. Some countries face a mountain of public debt (Japan and Greece are two good examples); for others, it is private debt that poses a problem (that of companies in China and Sweden, that of households and corporates in Denmark and Korea, for example), while others are constrained both by private debt and by public debt (Ireland, Spain, Portugal, Singapore). The only way to eliminate / reduce the risk premiums related to the solvency of states lies in the return of growth, the recovery of inflation, and the maintenance of low real rates. It is very difficult to have all this at the same time, and even more simply to have some of these conditions currently fulfilled: in the absence of such a configuration, five alternative solutions might emerge for some countries: 1) the default, 2 ) the restructuring, 3) the monetisation of the debt, 4) the continuation / implementation of asset purchase programs or 5) the pooling of debts, in the case of the euro zone for example. Such a decision would represent an additional leap towards federalism. In the current context, we can really doubt the leap to federalism, which amounts to focusing on the search for growth and maintaining a high ECB balance sheet for some time.

Q5 / Should geopolitical risks be permanently integrated?

A characteristic of the present and future period is the importance of political and geopolitical risks. These are so important and recurrent that they are now part of the natural landscape and must be integrated into portfolio construction as permanent risks. The rise of protectionism and more generally of “populism” is not a minor or isolated phenomenon, and all the more so because inequalities between countries, and within countries, have widened considerably. With the rise of emerging economies (China and Russia in the lead), new types of international relations are also emerging, with a shift in economic and political power to these economies. Since the beginning of 2010, global trade and, more generally, globalisation have been victims of this new balance. Can this (should it?) be extrapolated?

In the long term, several scenarios emerge, with two extreme situations: 1) a tendency to self-centrism or 2) greater international cooperation. We have been witnessing for some years now rising tensions between and within states (Spain and Catalonia the most recent example). The combination of state tensions and terrorist risks is giving rise to a fragmented and defensive world, with states seeking to protect themselves from external problems, thus forming “islands” in an ocean of instability. Growing self-centrism would reinforce the downturn in world trade and weak growth, and hence interest rates. Greater international cooperation would be likely to give greater impetus to growth. The second scenario is, by far, the most favourable.

Q6 / What scenario for the coming years?

For the years to come, it seems reasonable to us to bet on the following situation:

  • Lower structural growth than before the Great Financial Crisis;
  • Low inflation, but which is gradually becoming more of a concern, because of the sharing of value added (employees versus shareholders), the end of the disinflation / deflation exported by China whose role and influence are still changing... etc...;
  • Higher interest rates than today, but which remain low by historical standards (the current economic equilibrium justifies lower equilibrium rates than before);
  • That being said, the stronger growth environment, the probable rise in inflation and inflation expectations, the gradual end of central bank asset purchase programs... all this calls for a rise in short-term and long-term interest rates. Even if this increase will be moderate, except for a major shock, this seems to us to be the tendency for the next years;
  • Maintaining political and geopolitical risks at high levels, with tensions (and crises) remaining permanent phenomena;
  • An environment marked by immense transformations: megatrends, technological disruptions...
  • Significant underlying risks: the current low volatility, very low rates, tight credit spreads, valuations sometimes considered excessive... all this indicates that a correction phase (probably a significant one) will necessarily occur in the coming quarters or years. The financial markets live periodically in phases of complacency... we are currently in one of them.

 

1 The most pessimistic nevertheless go even further, and refer to secular deflation. Technical progress (new technologies, IT, robotics...) would therefore be globally deflationary because they allow to produce much more and much better with fewer employees (theme of “growth without employment”). Fiscal, tax and income policies, when rigour turns into austerity would also be deflationary because they would have the almost unique objective of allowing the payment of interest on the debt.

Expected Returns – short term and long term perspectives

Cash

The expected returns from rolling an investment in cash over the different holding periods are derived from Amundi’s projected trajectory of policy rates over the medium- to longer-term. In the eurozone, the nominal expected return on cash over 10 years is low at 0.8%, being very much influenced by the difficulty in normalising inflation and by a cautious view about the long-term growth prospects. Amundi’s monetary policy trajectory is derived from the estimation of an equilibrium real policy rate (defined as the real rate consistent with full employment and stable inflation in the medium-term) and from the projection of a normalisation path toward that equilibrium real rate. In the eurozone, we consider a neutral real rate at -1% since 2009 (approximately equal to ECB estimates) versus 1% before 2009 and we make the assumption of 0% in the longer-run. Regarding the start of the normalisation of interest rates towards neutral rates, a Taylor rule would point to a first rate hike in early 2019 based on the ECB’s economic projections and our equilibrium rate estimate. The last step of the estimation is to incorporate an inflation forecast, our projection is 1.7% over 10 years in the eurozone and 2% in the US.

Bonds

Our framework projects 10Y US Treasuries to return 2.6% over the next decade, while eurozone government bonds should return 1.2% per annum, a low nominal return given extended valuations and depressed starting yields. Those assumptions are based on a scenario of a moderate rise in bond yields. Building on the expected path for short-term real rates over the medium- to longer-term, we derive our bond yield forecasts adding the expected inflation over the holding period and a nominal term premium which is assume will remain low, leading to moderate rises in bond yields in our scenario. The term premium corresponds to the additional return that investors demand to hold a long-term bond as opposed to rolling over a short-term bond, and can be broken down into the inflation premium and the real term premium. In Amundi’s view, both of these will remain fairly moderate in our projected environment of low real rates and inflation.

Credit

Expected returns on corporate bonds remain low both in the eurozone and the United States, as they are being hampered by an environment of low risk-free rates and tight spreads. In our framework, USD IG should return 3.6% p.a. over 10 years, while EUR IG should achieve 1.3% p.a., all below historical averages and close to all-time lows. As a result, the credit premium will be moderate going forward: the excess return versus government bonds is projected to be 1% for USD IG versus Treasuries and 0.7% for EUR IG versus German bonds.

 

Forecast1

Equities

We project a rewarding risk premium (i.e. excess return versus bonds) for eurozone equities despite higher uncertainty regarding the macro outlook as investors question whether the current environment is cyclical or structural in nature. The valuation of eurozone equities is attractive versus government bonds; in addition, over the next three years, we anticipate outperformance by eurozone equities as we expect them to be supported by an improvement in corporate profitability. US equities should deliver a return close to the historical average but their excess return versus bonds is less attractive as US rates have pulled higher and US equities have outperformed while Europe has lagged. Expected returns on Japanese equities continue to be dragged down in absolute terms by low income returns and low inflation.

 

Forecast2

 

 

 

 

 

 

 

 

 

 

 

ITHURBIDE Philippe , Global Head of Research
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