June 2014
For professional investors only
The Fix
2014: The year of the “Boiling Frog”
by Simon Doyle, Head of Fixed Income and Multi-Asset
1. Overview
The last few years have rewarded investors. Attractive starting point valuations, recovering
economies and central bank policies explicitly aimed at inflating asset prices have clearly worked. It
is hard to find an asset class that hasn’t generated stellar returns during this period. Likewise, the
normal relationship between return and risk (or volatility) has generally prevailed – the more “risky”
the asset, the greater the reward (refer Figure 1 – below).
Figure 1: Realised 3 Year Returns to 31 May 2014
Historical Return v Volatility
16
Global Equities
(H)
Historical Return pa over 3 yrs
14
Global High Yield
(H)
12
REITs
Australian
Equities
10
Real Return Fund
8
Australian High
Yield
6
Fixed Income
Cash
4
EM Equities (H)
2
0
0
5
10
Volatility
Source: Schroders. Period ended 31 May 2014
15
20
25
As always, there are exceptions with returns from emerging markets defying this trend – hampered
by stretched valuations to start and the knock on effects of monetary policy in the developed
economies.
At the same time market volatility has collapsed with measures such as the VXO index, which
measures implied volatility on US large cap equities, trading at historic lows. Low volatility implies
relaxed and comfortable investors. An alternative interpretation is that extra-easy monetary policy
and reassuring words from central bankers is lulling investors into a false sense of security. Parallels
with the proverbial “boiling frog” come to mind. The temperature may be rising and the risk to
investors more significant than they currently perceive.
This article examines the rising risk in asset markets from the perspective of our return forecasting
framework. We conclude that valuations in key markets are stretched, future returns are diminishing
and the risk of loss is high (and uncomfortably so). Now is the time to be reducing risk in portfolios.
Issued by Schroder Investment Management Australia Limited
123 Pitt Street Sydney NSW 2000
ABN 22 000 443 274 Australian Financial Services Licence 226473
June 2014
For professional advisers only
2. Valuations, returns and risk
While looking backwards can be instructive, looking forward is clearly more important. Broadly
speaking the current debate can be separated into 2 distinct lines of thought – those that believe in
the power of extraordinarily easy monetary policy and liquidity to drive markets higher (and implicit
confidence in the deftness of the Fed) – and those concerned about rising complacency,
deteriorating value and the ability of central bankers to engineer a happy ending. We’re in the latter
camp (hopefully this is not a surprise to most).
An important anchor of our investment framework is the idea that valuations matter. In other words,
over time it is the interaction between the price paid and value that ultimately determines the risk of
an investment and its return. This idea is an essential element of our return forecasting framework
which anchors our asset allocation approach.
Figure 2 summarises our current risk and return forecasts – with risk shown not as volatility, but as
the probability of a negative return. Our return forecasts are derived as a function of longer run
factors (yield, growth and structural valuations) overlayed with cyclical valuation considerations.
Figure 2: Expected 3 Year Return and Risk Assumptions
Expected Return v Prob. of Loss
16
Expected Return pa over 3 yrs
14
12
10
Aus. Equities
EM Equities (H)
8
6
4
Global Equities
(H)
Aus. High Yield
REITs
Fixed Income
Cash
2
Global High
Yield (H)
0
0
10
20
30
Probability Of Loss
40
50
Source: Schroders
Comparing returns achieved over the last 3 years with our projections shows some marked
differences.




On balance, our return forecasts suggest lower returns from most asset classes than achieved
over the last 3 years – materially lower in many cases.
Return projections are relatively compressed across asset classes, but particularly within debt
markets reflecting low absolute yields and tight spreads;
Some of the best performers in recent years are offering weak future returns (eg. global high yield
and REIT’s);
The underperformers of recent years (Australian equities and EM equities) are now at the more
attractive end of the return spectrum – albeit both face some significant structural headwinds.
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June 2014
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More needs to be said about EM and I’ll return to this later.
With our return projections being largely driven from valuations, what is clear is the deterioration in
valuations is impacting future return potential of markets.
3. Valuations and Returns through time
An interesting exercise though is to compare our return forecasts through time – particularly to the
period prevailing prior to the Global Financial Crisis and how these forecasts have subsequently
evolved. This is especially relevant given the comparisons currently being drawn between today’s
market pricing and overall market environment and that in 2004-2007 period.
Figure 3: Schroders 3 Year Return Forecasts through time
3 Yr Returns:
US Equities
Forecast v Actual
40%
3 Yr Returns:
US High Yield Bonds Forecast v Actual
30%
30%
14%
25%
12%
20%
10%
15%
8%
10%
6%
5%
4%
0%
2%
‐5%
0%
‐10%
‐2%
3 Yr Returns:
US 10 Yr Bonds
Forecast v Actual
20%
10%
0%
Forecast
Actual
Forecast
Actual
Forecast
2014
2011
2008
2005
2002
1999
1996
1993
1990
2014
2011
2008
2005
2002
1999
1996
1993
2014
2011
2008
2005
2002
1999
1996
1993
1990
‐20%
1990
‐10%
Actual
Source: Schroders, Datastream, Bloomberg
These forecasts have provided a reasonable guide to market returns and over time. What’s notable
today is that US equity return forecasts and US high yield bond forecasts are now back to the
numbers that prevailed prior to the GFC. In fact, in the case of high yield, forecasts are actually
lower (mainly reflecting the lower absolute level of yields). Other equity markets (Australia included)
are indicating more positive returns, albeit in the short run the US influence will dominate – hence our
focus on the US above. A more stark contrast is in sovereign bonds where low absolute yields place
significant limitations on future returns.
As we noted above, valuations are not only a key driver of future returns, but also of risk. This is not
rocket science and reflects the idea that the more expensive an asset becomes, the more likely it is
that the owner of the asset will lose money (even if only in a mark to market sense) in holding that
asset. As volatility tends to fall as markets rise, risk (defined as the probability of loss) tends to be
negatively correlated with volatility.
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4. The Complacency Gap
The “flip side” of our return forecasts is risk. In Figure 4 we have aggregated the projected “risk of
loss” estimates from our “growth asset” return forecasts through time and compared this to equity
market volatility (VIX). We refer to this as the “Complacency Gap”.
Figure 4: The Complacency Gap
Complacency Gap
45%
70
40%
60
50
30%
25%
40
20%
30
15%
VIX Index
Probability of Loss
35%
20
10%
10
5%
0
Growth Assets ‐ Probability of Loss (LHS)
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
0%
VIX (RHS)
Source: Schroders
This simple analysis highlights several important points:


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The risk of loss in growth assets has been rising (rapidly);
That based on our forecasting framework the risk of loss has only been exceeded once since
1992 – and that was during 2006 and 2007 – just prior to the unravelling in credit markets;
The current “complacency gap” (ie. the difference between the implied probability of loss and the
market’s perception of risk as measured by the VIX index) was also only superseded immediately
prior to the GFC. It is interesting to observe that this was also a period in which Fed policy led to
sustained and unchecked credit expansion – only to end with a significant market re-pricing.
It is also worth looking at the defensive side of the investment universe. Figure 5 compares the
probability of loss from defensive assets against the same metric for growth assets shown above.
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June 2014
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Figure 5: Comparing risk in growth and defensive assets over time
Risk is rising in both Growth and Defensive Assets
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
Defensive Asset Probability of Loss
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
0%
Growth Asset Probability of Loss
Defensive assets = average of AU, US, UK Bonds
Growth assets = average of AU, US Equities and US High Yield Bonds
Source: Schroders
Figure 5 shows that while the sell-off in sovereign bonds during 2013 has alleviated some of the
future risk of loss from defensive assets, the risk of future losses nevertheless remains high. This
analysis implies roughly a 1 in 3 chance of negative returns from defensive investments (which
makes them not so defensive really) with a similar risk from growth assets in aggregate.
What’s also evident is that the implied probability of loss from defensive investments is not that
different to that on growth assets. While this does happen periodically its normally in environments
where the risk of loss is low. Importantly, this contrasts to the pre-GFC period where the risk of loss
on risk assets was high, but still low for defensive assets. In other words, while risk asset valuations
may not be as extreme as they became pre-GFC, there are limited places to hide. This is why cash
looks good.
5. Portfolio construction implications
The analysis presented is effectively the cornerstone in our thinking about current portfolio
construction – particularly in the context of the Real Return strategy.
While we would not claim that our return framework is perfect, it does provide us with a consistent
framework for thinking about future returns and where risk should be taken and avoided. Current
positioning clearly reflects the ideas presented above.
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June 2014
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Figure 6: Asset allocation of the Real Return strategy at 31 May 2014
Source: Schroders
Our current asset allocation reflects the following ideas:
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The relatively low equity exposure (28%) is consistent with declining prospective returns from
global developed market equities (the US in particular) and rising risk. That said, equities offer
better value than credit as well as some optionality on further policy inspired gains in risk assets.
Our bias remains to Australia given its higher starting point yields and recent underperformance;
We do concede the possibility that continued extraordinarily accommodative policy and full, but
not extreme valuations, could contribute to further gains in risk asset pricing, but, there is
diminishing headroom for further gains;
With risk rising and complacency high it may not take much to trip things up. Our list of catalysts
would be headed by a potential shift in rate expectations in the US, but the list would be long and
catalysts typically come from left field anyway. The key point to us is that deteriorating valuations
mean risk is rising and waiting for a catalyst means you could get left behind. Our strategy has
been and remains one of progressively reducing risk – particularly in those areas where risk is
the greatest.
While EM equity returns look solid, we remain concerned that a shift (even at the margin) to a
more normal policy stance in the US will lead to significant further structural underperformance
from EM;
With bond valuations suggesting low prospective returns (given both tight credit spreads and low
nominal yields) our defensive exposure is biased to cash;
While cash rates are low, rising vulnerability in both traditional growth and defensive assets does
favour cash as a store of value, and as an option on future opportunity.
The bottom line is that the longer central banks keep underwriting risk and the more comfortable
investors are that this is the norm, the more vulnerable investors become. Investors, like the
proverbial “boiling frog” may be feeling relaxed and comfortable (and still thinking that they will know
when it’s time to jump). This is not a good sign.
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June 2014
For professional advisers only
Disclaimer
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article.
They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274,
AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In
preparing this document, we have relied upon and assumed, without independent verification, the accuracy and
completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not
give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except
insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any
company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise)
for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or
otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be
relied on as containing any investment, accounting, legal or tax advice.
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