Jeffrey Knight, Head of Global Asset Allocation, Columbia Management
For asset allocation decisions, we find great value in maintaining a long-term outlook for major asset classes. Twice a year, in fact, we conduct an extensive update of our five-year return forecasts for several asset classes. The purpose of this exercise is two-fold. First, taking a longer term perspective helps us to set strategic asset allocations and design portfolios for diverse investment goals. Just as important though is that maintaining long-term forecasts provides context for responding thoughtfully to daily swings in market prices like those that we have seen over the past several weeks.
Chart 1 shows our forecasted five year total average annual returns for several major asset classes (2014-2018, compiled as of December 31, 2013).
Disclosure: The chart represents return forecasts for several asset classes. These forecasts are forward-looking based upon the reasonable beliefs of the Columbia Management Global Asset Allocation team and are not a guarantee of future performance. Actual results may differ materially from these forecasts.
From this chart we can extract a few of the major implications for strategic asset allocation over the next five years. First and foremost, we retain very modest expectations for total returns from fixed-income assets. This result derives directly from the low level of yields offered by major fixed-income asset classes combined with the expectation that interest rate policy will normalize within the next five years. We believe equities, meanwhile, offer returns that are only slightly below their long-term average levels. This forecast derives from an expectation of ongoing economic growth (and consequently, earnings growth), and worldwide equity valuations that are not extremely expensive. Accordingly, we find that portfolios designed to rely more upon equity risk than fixed-income risk are more likely to succeed, on average, across the next five years. That returns in early 2014 have behaved quite opposite to this longer term expectation is not terribly alarming, since falling bond yields simply make prospective returns in fixed income that much less attractive, and the corrections across equity markets have not been material in the context of an expectation of a healthy compounded return over five years.
We use these forecasts in another way, as well. Each time we update the five year view, we review each asset class with the goal of identifying cases where near-term (i.e. next 12 months) return is likely to materially differ from the longer term view. Said another way, we ask whether any of the asset classes are likely to experience a return pattern where performance is either front loaded or delayed. Indeed, we have two strong candidates this year whose near-term expected performance is quite different from their longer term forecasted averages. The first is fixed income generally, especially cash. We have no expectation of a hike in policy rates in the U.S. this year, so our expectation for 2014 returns from cash is near zero. The returns for cash, therefore, are expected to be back-loaded across the next five years. So too for other fixed-income classes, where the near-term returns suffer from an expectation of rising yields, but the longer term returns benefit from reinvestment opportunities. Frankly, our expectations for bonds in 2014 are even more meager than our already subdued five-year forecasts. The fact that bonds performed well in January, then, could present an opportunity to reduce duration when the current volatility storm subsides.
The other asset category to consider is emerging markets (EM). Here, we make the simple observation that investor flows turned negative during 2013, and provide an ongoing tactical headwind as 2014 begins. Current turbulence in emerging markets, in our view, may serve to reinforce this headwind during the early months of 2014. This is consistent with the expectations that we developed coming into the year and is the reason we have a neutral weighting on EM equities despite attractive valuations. Therefore, we are not compelled to rush to add risk from EM investments at the moment. However, if pressure on emerging assets produces substantial corrections, say, in the double digits, then the arithmetic could become compelling going forward. For example, if EM equities were to fall by 15% in early 2014, then a full year negative return is still possible even after a double digit recovery. Since we expect decent returns from emerging assets over a five-year horizon (driven by global growth expectations and attractive current valuations) we might find confidence to use extreme weakness in the near term to build strategic holdings for the longer horizon.
Maintaining a realistic set of expectations for long-term asset class performance is a key part of our investment process. These expectations can help us to make rational decisions in the face of market volatility. The research that underpins these forecasts, meanwhile, helps us to distinguish temporary trading volatility from more significant fundamental changes that could alter our longer term assessments. So far, market volatility in 2014 has not changed our outlook for the major drivers of our strategic forecasts, like economic growth, corporate earnings, interest rate policy or inflation. As always, we continue to closely monitor global markets and adjust our investment strategy accordingly.
The views expressed are as of 2/3/14, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
This material may contain certain statements that may be deemed forward-looking. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable.
The Barclays U.S. Aggregate Bond Index is a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $250 million par amount outstanding and with at least one year to final maturity.
The Barclays U.S. Corporate Investment Grade Index is an unmanaged index consisting of publicly issued U.S. Corporate and specified foreign debentures and secured notes that are rated investment grade (Baa3/BBB- or higher) by at least two ratings agencies, have at least one year to final maturity and have at least $250 million par amount outstanding. To qualify, bonds must be SEC-registered.
The BofA Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
The Standard & Poor’s (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks.
The MSCI EAFE Index is a capitalization-weighted index that tracks the total return of common stocks in 21 developed-market countries within Europe, Australia and the Far East.
The MSCI EM Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.
The JPMorgan Emerging Markets Bond Index Global (“EMBI Global”) tracks total returns for traded external debt instruments in the emerging markets, and is an expanded version of the JPMorgan EMBI+. As with the EMBI+, the EMBI Global includes U.S. dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million. It covers more of the eligible instruments than the EMBI+ by relaxing somewhat the strict EMBI+ limits on secondary market trading liquidity.
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