It is incredible to think we are already near the end of a stellar decade for investors. In this sense, we would prefer to reframe the 2020 outlook as the 2020-2030 outlook. In this light, the only way we can explain our outlook at this time is to set the background. Following the global financial crisis in 2008, interest rates sank across the developed world and stocks launched a 10-year bull-market run. Markets have cheered rising earnings and lower interest rates, but seemingly few people have paid attention to how long this accommodating landscape could last.
Our research shows that many assets are priced to deliver lower returns in the next decade or so, regardless of whether global growth slows now or later. Major markets have been overpriced for some time, in our view, including U.S. stocks and many bond markets. Generally, we believe that the future returns of most asset classes will not live up to those of the past decade, but some are much more attractive than others.
Put frankly, global markets are out of balance. And we expect rebalancing to come in the next decade. Performance gaps today between value-style stocks and their growth counterparts and between the U.S. and non-U.S. stocks have widened to historical extremes. For instance, U.S. equities have outperformed Emerging markets including Indian equities over the last three, five and ten years, highlighting the importance of diversifying portfolios across geographies. Looking across history, economies and markets tend to be cyclical—trees don’t grow to the sky, as the German proverb puts it. So, we expect the next ten years of returns to look very different to those of the last ten years. Our view isn’t based on proverbs so much as on market fundamentals.
The good news for our investors is that these rare extreme performance gaps have historically been followed by high relative returns for valuation-driven investing approaches. While these periods of strong cyclical returns leave investors susceptible to performance chasing, they can bring the best long-term opportunities for contrarians. In this sense, we believe benchmarks are vulnerable to larger downside risk than normal, although we do see opportunities by investing in unloved markets and diversifying in a manner that protects against the risks ahead.
How will 2020 play out? That’s anybody’s guess. Nevertheless, we see opportunities for investors willing to be patient and stick to a valuation-driven approach.
Question: Why are “risk-adjusted returns” more important than just “returns”?
People just care about the bottom line. When we talk about risk-adjusted returns, we are focusing on delivering the maximum amount of return for a given level of risk, as opposed to just generating returns without regard for the risk taken in achieving them.
This is an important distinction, because as humans, we like what’s easy and try to avoid what’s not. For investors, returns are easy, while the risk isn’t. Risk analysis feels opaque, theoretical, and even counterproductive during good times. When returns are rolling in, it is easy to ignore risk, then a crash happens, and it feels as important and alive as ever.
The lesson is simple: ignore the risk at your peril. But we would add to that—you need to focus on the right types of risks. We can usually bundle this into two core forms; 1) downside risks to your portfolio, or a permanent loss you can’t make back, and 2) overtrading risks, including poor timing decisions that trigger a permanent loss (especially those that would otherwise be temporary). Things like leverage, valuations, or becoming technologically obsolete are true risks. On the other side, volatility feels like risk, but we would argue it is less of a concern. For example, a market bobbing up and down is less risky than a market that carries unsustainable debt levels.
So, yes, risk-adjusted returns are important, as long as they are defined in the right way. We would even say risk management can make you money, as reducing drawdowns in market falls can be as important (if not more so) than keeping up with the market as it rises. This is especially true when you consider things like sequence risk, which is important for retirees. If your investment collapses by 50% in year one (from a market crash), it takes more than a 100% return to get back even, as you will be drawing on the capital when the balance is low.
Don’t be fooled into thinking goal attainment is all about catching positive returns. Those who think this way are procyclical, which is a risky way to invest as markets are unpredictable. To reach financial goals, consider those things you can control.
Question: Can you explain why being diversified across a range of asset classes will help investors outperform?
Diversification is often called “the only free lunch in investing” because the theorists have shown it increases portfolio efficiency by improving risk-adjusted returns. That is, you can get more return potential for a given level of risk, or you get the same return potential with less risk if you diversify. Diversification definitely helps; however, we believe its application needs clarification.
First, what is diversification? At its core, diversification means finding assets whose returns are less linked to those of other assets—that one asset zigs as another zags. Many are content for this to refer to past returns—that is, they look at how correlated the past returns of Asset A are to Asset B, and the less they are correlated, the more diversified they are. But we believe that we can’t look only at past returns to determine diversification for the future—we also need to consider diversification of the underlying fundamentals. A simplistic example is if Asset A is the stock of a company, and B is its debt. On paper, these are completely different assets and therefore provide diversification. To us, the investment success or failure of these assets rest on the same fundamentals—the business success of the company—and thus do not provide fundamental diversification.
Second, what does it mean to outperform? In any given year, diversification will deliver (by definition) lower returns than those for the highest-performing single asset class or security. However, when we broaden performance as being over an entire market cycle, we believe a multi-asset portfolio will typically beat single asset classes, especially on a risk-adjusted basis. Diversification can power this outperformance by limiting losses in down markets, meaning it can “catch up and pass” the high-flying asset classes, like equities, despite underperforming in rising markets. The rub here is a human one—can you stay invested through good times and bad?
Question: If a manager trails the benchmark over three or five years, despite delivering positive returns, should we be worried?
The question here is really about measuring investment success. So, let’s start with a sanity check—people aren’t usually investing for the sky. More often than not, people aren’t motivated by beating a benchmark or their friends, but rather, reaching their goals. This immediately brings the use of benchmarking into question, where we cite a misalignment between benchmark design and goals-based planning.
The best benchmark is one that is forward-looking and aligned to your financial goals. In a perfect world, every investor deserves their own framework to benchmark success, with transparency, measurement, and perspective all to be embraced. The challenge, of course, is that a forward-looking assessment is incredibly difficult to quantify, and there is no such thing as the “one-size-fits-all” approach.
Benchmarking tools—such as those we use—are powerful, but you cannot unshackle the backward-looking nature of them. What matters to an investor is whether their investment might be expected to help them achieve long-term gains in the future. This mismatch requires care and highlights an important point around process versus outcome. There are many moving parts, some of which you can control—risk taken, assets held, timeframe considered—and many others that you can’t.
Specifically, it is entirely possible to have a strong process (or a good decision) with a bad outcome, just as it is possible to have a poor process with a strong outcome. However, more often than not, a strong process will prevail and result in strong outcomes and vice versa. This is a key reason why we stress that people make comparisons over a long time horizon—it allows the strength of the process (or the combination of many decisions) to unveil itself.
To round this out and answer the question directly—three to five years is a decent progress check, however, looking backwards is unlikely the answer. We wouldn’t be so worried, as long as the inputs (people, process, parent, costs) continue to stack up. Remember that you can’t reap the benefits of a manager’s strong past performance.
Outlook on Markets
Indian equities saw a sharp run-up between 2014 and 2017 amid a host of factors such as a new government with a strong mandate at the center, domestic and global economic recovery, and an improvement in corporate earnings. This resulted in lofty valuations with price/earnings multiples rising sharply for the large cap, midcap and small cap segments. After the runaway bull market, volatility returned to the markets in 2018 as concerns over a global trade war and Brexit dented market sentiment. Risk-off sentiment flowed around the world, with Foreign Portfolio Investors (FPIs) pulling out approx. $4.3 billion from Indian equity markets in 2018. Large cap market indices have risen to record highs in 2019 driven by strong FPI and DII flows (about US$ 14 billion and US$ 6 billion respectively) on the back of the return of the incumbent government to power, and a corporate tax cut to boost the sagging economy. However, the rally has been a polarized one with a small basket of stocks contributing to the bulk of the index gains. All this amid a slowing domestic economy (driven by a sharp fall in consumption and investment) and looming global recessionary risks. From the peaks of January 2018, the midcap and small-cap segments have seen a sharp correction with expensive valuations moderating to an extent. Given this backdrop, we are underweight domestic equities, although the underweight positions in the midcap and small-cap segments have been reduced in recent times with moderation in valuations. Our estimated 10-year valuation implied returns are driven by a strong trend growth and improving earnings for the Indian markets – with the corporate tax cut expected to provide a fillip. We think that corporate earnings growth will improve as domestic consumer demand, export, and private expenditure sees a revival. This, along with the implementation of additional fiscal and monetary measures, should bode well for the economy. On the international front, based on our 10-year valuation implied returns, we are underweight the U.S. markets, given the stretched valuations on the back of loose monetary policy to support the prolonged economic expansion; and we are overweight the European and Asian (ex-Japan) markets given their sound return potential based on current valuations.
On the fixed-income side, the RBI has cut the policy rate by 135 bps in the year to date period, with the transmission being about 44 bps on fresh loans. Lending rates on fresh loans are expected to come down further with rates being linked to external benchmarks. The surplus liquidity in the banking system has so far not translated into higher credit growth mainly due to subdued business and consumer sentiments, accompanied by lower risk appetite of banks to lend particularly to the corporate sector on the back of rising NPAs over the last few years. Recently, headline inflation has spiked up driven by higher food prices although core inflation remains subdued reflecting the slowdown in the economy. Cash rates have fallen sharply with the cut in policy rates and surplus liquidity. Real rates at around 1.5% to 2% for the short term (1 to 3 years maturity) and medium-to-long term (5-to-10 years maturity) segments continue to look attractive, as yields at the longer end may face additional supply pressure given concerns on the fiscal front. We continue to be overweight short-term and medium-term debt amid attractive real rates. We are at neutral or benchmark allocation level on long-term debt. We are mindful of a possible fiscal slippage amid the subdued GST collections and corporate tax rate cut, and of the effect that any incremental borrowing by the government would have on yields at the longer end of the curve.
2020 promises to be an interesting year with all eyes watching the government’s next moves to revive the sagging economy, juxtaposed with large cap indices starting the year near all time highs driven by liquidity chasing a limited basket of stocks.
