The following is excerpted from commentary that appears in the April issue of No-Load Fund Analyst, published by Litman Gregory. For more information on accessing the full issue of No-Load Fund Analyst, click here.
These scenarios are the foundation for our five-year asset class return estimates, which are a primary input into our tactical asset allocation decisions. The first thing to note is that our qualitative expectations for each scenario have not materially changed. These are essentially the same scenarios we have been using for the past few years, although we did adjust the verbiage for some of them. The changes to our inflation and interest rate assumptions do not have a material impact on our assessment of the risks and returns (although they do change the expected returns for some of the income-oriented asset classes).
Our updated four broad economic scenarios looking out over the next five years, from most negative to most positive, are as follows:
Severe Recession: We experience a severe recession, e.g., due to another financial crisis or debt crisis, with a weak recovery in the later years. Assumes inflation is around 1% and the 10-year Treasury yield is around 2% at the end of year five.
Changes: We reduced our inflation assumptions in this scenario from 2% to 1%, and the 10-year Treasury yield from 4% to 2%. In other words, we assumed a less robust recovery by year five would imply a lower nominal Treasury yield and a lower real yield (net of inflation). Given how depressed real yields currently are, and our expectation that the Fed will want/try to continue to keep them low in order to support asset values and debt reduction, we decided to make this change. We also took into account the current low level of Treasury yields.
Stagflation: We experience subpar economic growth, but with a strong inflation spike towards the end of our five-year horizon. Assumes inflation is around 6% and the 10-year Treasury yield is around 7% at the end of year five.
Changes: We increased both inflation and the 10-year yield in this scenario by one percentage point to 6% and 7% respectively. We wanted to give this scenario a bit more extreme of an inflationary outcome relative to our other scenarios to reflect what we believe remains an unusually wide range of potential macro outcomes over the next five years (the inflationary tail risk).
Subpar Recovery: This is our “most likely” (base-case) scenario. The subpar recovery continues, but a recession is probable within the five-year horizon. Assumes inflation is around 3% and the 10-year Treasury yield is around 5% at the end of year five.
Changes: We kept inflation in this scenario at 3% but reduced the 10-year yield by one percentage point to 5%. i.e., we reduced the real yield from 3% to 2%.
Average Recovery: A recession is avoided and the economy recovers due to a combination of effective government policy and positive self-reinforcing economic and business cycle dynamics (increased income fuels increased spending leading to increased hiring which leads to increased income, etc). Reflation works, but the Fed avoids significant monetary inflation. A global rebalancing process (e.g., between creditor/saver nations and debtor/spender nations) occurs. Assumes inflation is around 3% and the 10-year Treasury is around 6% at the end of year five.
Changes: We did not change our assumptions for the average recovery scenario, which reflect rough historical averages for inflation and real yield.
The updated scenario assumptions do not change our return expectations for equities because our equity analysis is not based on precise interest rate or inflation assumptions. Our equity return estimates are driven by our earnings growth estimates, valuation multiple assumptions, and dividend yield, and we did not change any of those variables as a result of our scenario update.
In contrast, our return estimate for fixed-income asset classes and REITs are directly impacted by our interest rate and inflation assumptions. However, as noted above, the impact is not material enough to alter our view that they are relatively unattractive. For example, in the severe recession scenario, our expected annualized five-year return for core investment-grade bonds improved from around 1%, to around 1.9%. That is still an unattractive return. Likewise, in our base-case scenario the investment-grade bond returns changed from around 0% to around 0.7%
It is worth reiterating that we are not trying to precisely forecast inflation and interest rates five years from now. We are trying to draw scenarios we think could be approximately right and have at least a reasonable likelihood of happening, although of course we think the likelihoods differ across the scenarios. Then for each scenario, we estimate annualized returns for various asset classes, which in concert with our risk-management analysis feed into our portfolio construction and asset allocation decisions.
While these scenarios and our tactical decisions are constructed with a five-year time horizon, we also need to be cognizant of the potential paths that the economy and markets might take over the nearer term to arrive at the five-year destination. This is particularly relevant for our portfolio risk management, where we have a 12-month time horizon. In the current environment in particular, we can easily envision the first few years of the five-year horizon looking very different from the ending years—for example, in terms of inflation and interest rate risk (a relatively low risk up front, but potentially a big risk later on).
Our discipline is to keep focused on the long term (when we believe fundamentals and valuations ultimately converge), while remaining flexible and nimble through this highly unstable, uncertain, and unprecedented macro environment. We remain opportunistic and tactical—ready to move quickly to mitigate portfolio risk (e.g., as we did in late November), or to take advantage of compelling long-term expected return opportunities even in the face of shorter-term risks, uncertainties, and market fears (as we did in August and September). At the moment, given the strong market rally of recent months and the risks/headwinds we still see on the horizon, we are closer to the former than the latter.
So how are we positioned and why?
In our balanced portfolios, we remain underweight to equities/equity-risk and underweight core bonds/interest-rate risk. We see relatively attractive tactical opportunities in emerging-markets local currency bonds, absolute-return-oriented fixed-income funds, and alternative strategies (such as arbitrage). Emerging-markets stocks' long-term returns look reasonable on an absolute basis and are attractive relative to U.S. and developed international expected returns. But we also assume emerging-markets stocks will have greater volatility than U.S. stocks in the shorter term, and, we believe there is a meaningful risk of a China hard-landing within our five-year horizon. Therefore, in balancing the various risks and in concert with our emerging markets local-currency bonds position, we do not want to increase our dedicated emerging-markets equity exposure at this time.
The table above shows our current balanced portfolio target asset allocations versus its 60/40 stock/bond strategic allocation as of March 31, 2012.
