Seven asset class predictions for late cycle investment

With a recession potentially on the cards as soon as 2020, investors are already looking for ways to weather the storm.

Robeco's annual Expected Returns report outlines the firm's forecasts for 2019-2023 and which assets are over or under valued.

Head of investment solutions at Robeco Bart Oldenkamp said: 'It is clear that the investment environment could change dramatically in the next five years and that current conditions are already quite challenging with compressed spreads, widespread overvaluation in the major asset classes and low volatility.

'Investors should not forget that patience is a virtue in the world of investing too, as we believe that there are still opportunities to harvest risk premiums in the major asset classes.'

Here are the firm's outlooks on seven asset classes.

General outlook for returns

Robeco expects equities to be the best-performing asset class over the next five years, with emerging market stocks returning 4.5% a year and developed markets 4% for euro investors.

Meanwhile, it believes German government bonds will deliver negative returns of -1.25% a year, while developed global government bonds should return -0.25%.

Emerging market debt in local currencies is seen returning 3.75% a year, while investment grade corporate bonds should deliver 1% and high yield (non-investment grade) credits, 1.5%.

In its paper, Robeco delves deeper into each asset class to outline the basis for its forecasts...


US equities

[Robeco says] 'We revisit the famous Shiller Cape [cyclically adjusted price-earnings ratio] to find out what it can tell us about the valuation of the US stock market.

'The current level of the Cape's deviation from 40-year mean and subsequent five-year returns (pictured above) demonstrates that investors are willing to pay a premium for 10-year real average earnings.

'As the Cape generally mean reverts through lower equity prices, a high Cape in principle points to a valuation risk for investors.

'Cross-checking with other valuation indicators only confirms the signal.

'Tobin’s Q [the market value divided by the replacement value of US firms] now stands at 1.11, implying that the market value exceeds the underlying asset base by 11%.'



Global equities

'Of the key developed markets, the US is the furthest on in the economic cycle. Valuations should reflect this: one can expect the US market to be the most expensive.

'Although global stocks have overall been more expensive than last year, not all regions show the same stretched valuations compared to their own historical figures.

'With the global Cape at 23.8, our simple regression model  suggests that returns on global equities will be below the historical average for the next five years.

'The current regional differences in valuation have been quite persistent, since the expansion began in 2009. 

'Relative valuations could be on the move in the next few years now that compensation for taking risk in the leading US equity markets has deteriorated further.

'The Cape of emerging market versus global Cape now shows a discount of 35% up from 31% in September 2017. At the margin, this has created some upside return potential in emerging markets compared to last year.'


Government bonds

'To determine the value of government bonds, we first look at our steady state framework. In this framework, the real return on government bonds is 1.25%, which is the sum of a 0.5% real return on cash and a 0.75% term premium on bonds

'We derived a historical median real return of 1.75% and a GDP-weighted global bond index return of 1.82%. The historical bond returns captured 80% of economic growth. On this basis, our steady state real return estimate would correspond to GDP growth of roughly 1.6%.

'In its 2016-2021 forecast, the IMF expected inflation to average 1.27% for the eurozone. This level is far below the ECB target, but close to 2% over the medium term. Clearly, with such expectations, our simple steady state assumptions will be off the mark.

'With the return of synchronized global growth since 2016, expectations have been moving back to levels one would predict in a steady state world.

'However, so far, real bond yields [in above table of JPMorgan GBI yield versus fair value estimate] have not followed suit.'

Developed currencies

'Nominal exchange rates can significantly under- or overshoot inflation differentials causing deviations from relative purchasing power parity (PPP).

'Deviations from trend relative PPP [see above] show a strong mean reversion over a period of five years, causing corresponding changes in nominal exchange rates.

'The view that a lot of exchange rate behavior is ultimately driven by changes in real exchange rates as real output shocks are translated into currency movements, underpins our valuation framework.

'Our framework points to an appreciation of the euro against the US dollar as the real exchange rate of the dollar is now 16% above the fair value based on the trend relative PPP.

'Assuming a return to fair value, the USD should depreciate 3.4% year-on-year versus the EUR. By contrast, the Japanese yen is expected to appreciate.

'We conclude that the yen is 20% undervalued which corresponds to an annualized appreciation of 3.7%.'

'It seems wise to hedge the risk of a USD depreciation.'


Corporate bonds

'[The above graph] shows the different deciles for the Global Aggregate Corporate index.

'The line shows our latest observation, which is equal to the median. This seems to indicate that the valuation of the market is neutral.

'However, if we look at the numbers at the rating level, the market looks slightly expensive.

'The option-adjusted spread over Treasuries for single-A and triple-B corporate bonds is close to the 40th percentile.

'Still, the difference between the 40th and 50th percentile is rather small: only 10 basis points for a single-A rated bond.'

Emerging market debt

'Local bond return is attractive for investors as the yield of the index tops that of developed markets [see above].

'The yield of the emerging market index is trading at the average level and is 5% higher compared to that of developed markets.

'The lowest annualized bond return for a five-year period is 5.6%, which is well above yields of developed sovereign bonds.

'The inflation gap between emerging market and developed market countries is expected to narrow. The IMF expects 3.6% for emerging markets versus 1.9% for developed markets for the coming five years.

'Taking the IMF forecast as a proxy for the market, emerging market bonds offer a 3% real yield. We believe this is a relatively attractive starting point. 

'Emerging market local currency debt is still attractive in the medium term compared to other fixed income asset classes both in terms of yield and, in particular, when it comes to investments in USD.'


Listed real estate

'Listed real estate is a sector within the equity universe and hence bears many similarities to global equities as regards risk and volatility.

'We revisit our comparison based on a Cape-like valuation metric [see above] for listed real estate to compare valuation levels with that of global equities.

'According to this metric, the discount on real estate has increased since last year, now at 25% up from 23.1%.

'The relative dividend yield has increased modestly to 1.48 from 1.4 last year, now 9.5% below the average level of the past 20 years.

'Both metrics confirm that real estate has become less expensive compared to global equities but is not yet truly attractive. Our valuation tilt for real estate compared to equities is neutral.'