CAPITAL MARKETS
FORECAST 2016
CREATIVE SOLUTIONS FOR A RETURNS-CHALLENGED WORLD
TABLE OF CONTENTS
CAPITAL MARKETS
FORECAST 2016
Executive Summary.....................................................................................................................2 Why we project meager growth for the foreseeable future. .............................................................4 Key Themes for the Next Seven Years..........................................................................................10 Creative Opportunities.............................................................................................................21 Outlook on commodities and commodities-related investments............................................21 Private Capital Roadmap.................................................................................................25 The Case for Private Capital......................................................................................25 The Risks of Private Capital.......................................................................................26 The Implementation of Private Capital. ........................................................................27 Building a Private Capital Allocation. ........................................................................27 The European Refugee Crisis- Opportunity or Risk?............................................................28 History of Mass Migrations.....................................................................................28 Historical migrations compared to today. ..................................................................29
What is the current situation?..................................................................................29
How has Europe responded to the flood of refugees?..................................................30
What is the future?.................................................................................................30
Appendix................................................................................................................................32
Expected Return and Risk Assumptions across Building Blocks..............................................32
Correlation Assumptions across Building Blocks. .............................................................32 Drawdown Targets.......................................................................................................32 Building Block Strategic Weights...................................................................................33 Building Block Ranges..................................................................................................34 Prism Inputs.................................................................................................................35
CAPITAL MARKETS FORECAST 2016
1
EXECUTIVE SUMMARY
W
elcome to the 2016 edition of the Balentine Capital Markets Forecast. This annual research piece is the lifeblood of our investment structure and strategy,
THE ART & SCIENCE OF INVESTING
as projections form the basis for portfolio construction both within and across
building blocks. The Investment Strategy Team has honed this process over many years, and it has a demonstrated positive track record, notably at market extremes. Projections made in the Capital Markets Forecast help design strategies that will increase the probability of hitting individual goals by maximizing risk-adjusted returns for clients with different levels of risk aversion. Risk budgets are not random; they are based on the long-term historical outcomes of bond and equity benchmarks. They are bookended by the Conservative portfolio that represents the risk level of a 100% bond portfolio and the Aggressive portfolio that represents the risk level of a 100% equity portfolio. In between are our Balanced and Growth strategies. Moreover, for each of our four levels of risk aversion, we have Public Market and Fully Diversified options, which exhibit tradeoffs between reducing volatility and the ability to achieve outsized upside.
Balentine’s building block framework is as follows: Liquid – Assets in this building block insulate near-term spending needs and seek to protect against interest rate and credit risks. An allocation to Liquid reserves helps avoid permanently impairing capital when portfolios need to meet frequent distribution requirements. Safe1 – Safe assets primarily play a role as a “shock absorber” to strategies, with the goal of providing protection when risk assets experience short-term duress. Secondarily, they provide income while managing against interest rate fluctuations, credit risks, unanticipated movements in inflation, and currency movements. Market Risk – The most volatile component of strategies, Market Risk assets aim to capture public market equity returns, as they are driven by exposure to underlying economic growth, earnings, and current and expected future interest rates. Manager Skill – Manager Skill assets are allocated to highly active managers who seek to generate excess returns over the medium term by managing towards an absolute return target. Manager Skill can play both an offensive role in generating returns and a defensive role in providing an additional shock absorber to strategies. Private Capital – As they are illiquid, these assets are not available in public markets. Private Capital assets can achieve strong returns over the long term significantly in excess of public markets, enhancing income generation and capital appreciation.
2
1
No implication ‘Safe’ assets cannot lose value.
CAPITAL MARKETS
FORECAST 2 2016
In a world that has become returns-challenged primarily on account of central bank interest rate policies, finding creative solutions in both public and private markets has become paramount. In public markets, we continue to search for areas where structural reform exists and central bank policies are not the end all be all. Though we are less optimistic about the outlook for public markets than others, our creative selectivity in portfolio construction should capture any upside in this area. In private markets, we look to investments that offer returns driven by sustainable sources that are not accessible through the public markets. “Chasing yield” in today’s environment may be especially dangerous; investors need to take intentional risk in unconventional ways to boost income and returns. Our research is uncovering such investments, which will allow us to take on risks in a thoughtful manner without necessarily moving our clients further out on the risk spectrum.
THIS ANNUAL RESEARCH PIECE IS THE LIFEBLOOD OF OUR INVESTMENT STRUCTURE AND STRATEGY AS PROJECTIONS FORM THE BASIS FOR PORTFOLIO CONSTRUCTION BOTH WITHIN AND ACROSS BUILDING BLOCKS.
The first and second sections of our Capital Markets Forecast contemplate why we believe growth will be limited for the foreseeable future and the themes we see over the coming cycle as a result. There is some similarity to recent editions as it relates to prospective market returns. However, we expand upon those themes to discuss how we plan to implement creative solutions to address our weak public market outlook. The next section looks at some of these potential opportunities: 1) The outlook for commodities, 2) building a private capital allocation, and 3) the potential impacts of the refugee crisis in Europe. These are not included merely for academic discussion, but rather to underscore how we are thinking about potential ways to boost returns looking forward. The Capital Markets Forecast concludes with an appendix containing assumptions on risk, returns, and correlations for building blocks, strategies, and PRISM inputs over the next seven years.
CAPITAL MARKETS FORECAST 20163
3
THE ART & SCIENCE OF INVESTING
WHY WE PROJECT MEAGER GROWTH FOR THE FORESEEABLE FUTURE Five key issues support our outlook of continued meager growth for the upcoming investment cycle: 1. Economies, in aggregate, remain over-indebted and deflationary. Private deleveraging since the Global Financial Crisis has mostly been offset by increases in government leverage. Deflation has not yet run its course; rather, it is accelerating as evidenced by the commodity complex. 2. In order to soften the deleveraging process and combat deflation, central banks effected monetary stimulus. While the intent was to help the real economy, stimulus was actually channeled toward elevating asset prices, thus perpetuating deflation in the real economy. 3. Poor demographic trends, some independent of the deleveraging and others as a result, will continue to limit aggregate demand, further disseminating worldwide deflation. 4. Given economic weakness, corporations will continue cutting expenses, notably labor, in lieu of equity repurchases. This is a short-term attempt to grow earnings per share (EPS), and consequentially equity prices, in the face of valuations that are unlikely to expand. Demand will further weaken as the labor participation rate continues its descent. 5. In the face of deflationary headwinds, GDP growth will be driven by gains in productivity, which we expect will not be enough to outpace the sluggishness. Despite the sharp run-up in equity markets over the last seven years, the name of the game to us is still the four Ds: Debt, Deleveraging, Deflation, and Demographics. As long as the world struggles to manage debt ratios, deleveraging and deflation will cap worldwide economic growth. While we have seen fits of starting and stopping among various global economies since the Global Financial Crisis, nothing sustainable has emerged. As a result, central banks have remained all too accommodative in an effort to drive growth. The question we now ask: have central banks’ efforts hit a wall given the little bang they are getting for their buck? $ Growth in US GDP per $ of US Debt Increase (Rolling 2-Year Periods)
Figure 1: Additional debt has become less productive in driving economic value. Source: Federal Reserve
$0.90 $0.75 $0.60 $0.45 $0.30 $0.15 $0.00 (-$0.15)
4
(-$0.30) 1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
2004
2009
2014
CAPITAL MARKETS
FORECAST 2016 Not unlike companies that hit a leverage wall, overleveraged economies need to work off the excesses in the system, often over a long period of time. That translates to a plethora of false starts in economic growth. Though we have seen deleveraging in the private sector, much of this has come on the back of increased debt in the public sector, thus negating much of the effect. Deleveraging historically results in deflation that runs its course only when debt has been moderated. Colloquially, deflation is often referred to as falling prices; however, focusing merely on prices tends to miss the bigger picture. Falling prices do not define deflation but rather are a symptom. Deflation is really a function of slowing money velocity and a persistent shortfall in aggregate demand versus capacity, both of which drive the resulting price declines. Actual deflation has, of late, commonly been referred to as “secular stagnation.”2 Given the heightened focus on central bank actions all over the globe, it has become more essential to understand the reasons for and potential impacts of central bank policies. Not only have central bank policies been relatively ineffective in stemming the tide of deflation, but their actions may actually be perpetuating the issue, as deflationary signs exist all over the world today: • In Europe, there is a lack of aggregate demand and now an influx of potentially cheap labor in the form of migrants. • A debt crisis is brewing in the Emerging Markets owing to dollar-denominated debt growing due to the strengthening dollar. • US companies are not investing in growth and productivity relative to the amount of cash they are putting toward shareholder returns, notably in the form of equity repurchases.
Central banks’ attempts to inflate their own domestic economies via low interest rates are exporting deflation elsewhere via currency devaluation (for those on a fixed currency system such as China) or currency depreciation (for those on a floating exchange rate system). In isolation, each central bank’s actions may have been effective within its own country. Globally, however, this course of action has had an inverse effect, as foreign central banks collectively have overwhelmed each central bank’s domestic inflationary intentions. Thus the world remains deflationary. Falling commodity prices and weakening credit conditions support this. Short-term interest rates have been trending down over the last 30-35 years (Figure 2), with rates brought to effectively 0% in 2008 in the face of the Global Financial Crisis. Although lowering interest rates is generally the course of action to stimulate a slowing economy, excessively low interest rates in the wake of the crisis were brought about for an additional reason: to alleviate the burden on debtors’ abilities to service their bloated balance sheets (Figure 4). All else equal, the reduced interest burden on debtors would allow more household cash flow to go toward productive economic spend and servicing debt principal. While this dynamic was a factor in assets’ comeback from the brink after the Global Financial Crisis, it has also brought about a disconnect between asset prices and economic growth. Moreover, capital allocation discipline has not allowed for the proper economic healing, as savers have been forced further out on the risk spectrum in order to achieve desired yields. This inevitably leads to disappointment, as we have seen of late in the MLP3 space, for example. Additionally, the risk tolerance mismatch in portfolios over the last few years has driven down investment yields as the demand for risky investments outweighed the supply, similar to what occurred during the housing bubble. 2
Secular Stagnation: Facts, Causes and Cures. Ed. Coen Teulings and Richard Baldwin. London: CEPR Press, 2014.
3
MLP is a Master Limited Partnership, which is a publicly traded Limited Partnership security that receives pass-through tax benefits. In order to qualify for A the preferential tax treatment, the entity must receive income from an IRS-qualifying source and distribute the majority of profits via high-yielding distributions. These arrangements are prevalent in the energy space, notably in pipeline businesses that theoretically have relatively stable income streams.
CAPITAL MARKETS FORECAST 2016
5
Figure 2: Short-term interest rates have trended down with progressively lower peaks. Source: Balentine
Federal Funds Rate History (%) 20.0 17.5 15.0 12.5
7.5 5.0 2.5
Incen ve to borrow to fund malinvestment
Too much money chasing too few opportuni es in asset markets and economic sectors
Financial asset infla on beyond fundamental jus fica on
Lower rates
Asset bubbles and overcapacity Capital destruc on as returns on capital do not meet economic hurdle rates
2016
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
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1984
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1980
Figure 3: The self-sustaining cycle of low short-term interest rates. Source: Balentine
Declines in financial assets and economic growth
6
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
1958
1956
0.0 1954
THE ART & SCIENCE OF INVESTING
10.0
CAPITAL MARKETS Figure 4: Low short-term interest rates have been necessary to effect an orderly deleveraging. Source: BCA Research
US Private Debt as % of GDP
FORECAST 2016
180.0% 170.0% 160.0% 150.0% 140.0% 130.0% 120.0% 110.0% 1995
2000
2005
2010
2015
Euro Area Private Debt as % of GDP 180.0% 175.0% 170.0% 165.0% 160.0% 155.0% 150.0% 145.0% 140.0% 135.0% 130.0% 125.0% 1995
2000
2005
2010
2015
UK Area Private Debt as % of GDP 220.0%
200.0%
180.0%
160.0%
140.0%
120.0%
100.0% 1995
2000
2005
2010
2015
CAPITAL MARKETS FORECAST 2016
7
THE ART & SCIENCE OF INVESTING
Low interest rates have created a conundrum for the Fed, as two concerning consequences have resulted: 1) much of the excess reserves in the banking system were channeled into financial assets rather than into the real economy, and 2) artificially low hurdle rates encouraged companies to borrow to repurchase increasing amounts of equity and investors to borrow to fund investments. This cycle, as illustrated in Figure 3, can lead to eventual asset declines and yet another round of interest rate cuts. We have seen this cycle multiple times, notably with the 1991 recession, the bursting of the internet bubble, and then the bursting of the housing bubble. Subsequent rate hikes never made it back to the prior peak, as shown in Figure 3. Moreover, low rates as a result of central bank policies have become self-perpetuating, thus effecting a permanent impairment of returns, a theme we will touch on later. Demographics present another headwind. We have heard for years about Japan’s aging population and the concerns that may present for economic growth; however, additional concerns have asserted themselves globally. In the US, the labor participation rate has been in decline since 2000, after peaking at slightly above 67% (Figure 5). Some estimate that the US labor participation rate may not begin to grow again in the mid-2020s. That would make for almost 35 years without substantive appreciation domestically. Amazingly, the US experience pales in comparison to Europe, where labor participation force declines are estimated to continue until nearly 2050, amplified by the ongoing and forthcoming immigration.4 Figure 5: The US Labor Participation rate is at a 38-year low and shows little sign of abating. Source: The US Bureau of Labor Statistics
US Labor Par cipa on Rate 68%
66%
64%
62%
60%
58% 1950
4
8
1961
1972
1983
1994
2005
L oichinger, Elke, “Labor force projections up to 2053 for 26 EU countries, by age, sex, and highest level of educational attainment,� Demographic Research 32.15 (2015): 443-486
2016
CAPITAL MARKETS
FORECAST 2016 Aside from immigration and aging baby boomers, there is one tremendous demographic hurdle that is strongly deflationary – automation. A recent Bank of America research report estimates that within a decade, robots will take 50% of manufacturing jobs and save $9 trillion in labor costs. While this sounds great for company profits, the reality is that companies cannot make money in the long run simply by cutting costs. As long as a substantive level of the labor force is not participating, aggregate demand will remain low, which should eventually affect the companies’ top lines – a classic deflationary spiral.
it is our job to be vigilant and creative in finding these opportunities, despite the challenges created by global secular headwinds.
In the face of challenging leverage and demographics conditions and in the absence of central banks and governments making the hard decisions to cause shortterm pain (something they have been loath to do so far), how do economies begin to grow again? Quite simply, it will take another leap up in economic productivity, with those remaining in the labor force generating even more per capita. Surely automation will help with this, but it is our belief that this is not enough. Additional productivity through more efficient capital allocation and better alignment of worker skill sets and required tasks will have to come about in order for substantive real GDP growth to resume. What does this mean for asset markets in the future? While any seven-year cycle may be able to deliver tactical opportunities among the different asset classes, structural bull markets in most asset classes likely will not assert themselves until after deleveraging and deflation run their course. This creates a difficult environment for investors to bridge the gap between their goals and what opportunities are available. It is not enough for us to point out these concerns looking forward. Rather, it is our job to be vigilant and creative in finding these opportunities, despite the challenges created by global secular headwinds.
CAPITAL MARKETS FORECAST 2016
9
KEY THEMES
THE ART & SCIENCE OF INVESTING
O
FOR THE NEXT SEVEN YEARS
ur Capital Markets Forecast process always begins with an assessment of the starting point for our upcoming seven-year forecast window. As we enter 2016, we are almost seven years into a domestic equity bull market run that has
defied many investors’ expectations in both duration and magnitude. With strong equity markets come concerns about future returns across a host of asset classes. Today’s landscape offers few markets priced for compelling opportunities, as recent strength has brought forward years’ worth of returns. With that said, there are still opportunities, but successfully navigating these opportunities will necessitate more discernment in the absence of uniformly accommodative central bank easing. In other words, it is no longer going to be enough for investors to be in the right neighborhood; rather, investors will have to be on the right street in the right neighborhood and perhaps even the right house on the right street in the right neighborhood. It is under this context that we introduce our key themes for 2016: 1. Low interest rates are likely to persist for longer than the market is currently pricing. Even with the recent Federal Reserve action to lift the Fed Funds Rate, we expect shortterm and long-term interest rates to remain relatively low for years to come, significantly impacting public market returns. 2. We now anticipate a slower trajectory for interest rate increases. This will dampen bond returns versus our prior expectations. While our Safe building block will continue to serve as a shock absorber during sudden equity market volatility, the efficacy likely will be more muted than in the past during extended equity market drawdowns. 3. Projected equity market returns remain paltry, with slightly improved international returns offsetting weaker domestic returns. A key theme in our 2015 Capital Markets Forecast was to look to international markets for a greater contribution to the success of the Market Risk building block. In contrast with last year, however, international opportunities are even more selective, which may necessitate the use of more tactical Art opportunities within Market Risk. 4. The risks and meager projected returns for public markets underscore the importance of Manager Skill and Private Capital. More so than in the past, contributions from Manager Skill and Private Capital will be key for strategies to achieve their long-term objectives going forward. In fact, in the absence of allocations outside of public markets, it likely will take increased contributions to achieve investment targets.
10
CAPITAL MARKETS
FORECAST 2016
5. Given the permanent impairment of returns from central bank policies, our Objectives (formerly known as the “Primary Benchmarks”) ranging from inflation+1% to inflation+4% are realistic hurdles for our strategies. While many investors aim for higher rates of return than our Objectives, we believe such attempts may come with undue risks at a time when markets are not priced to deliver such lofty returns. Low interest rates are likely to persist for longer than the market is currently pricing. This will constrain public market returns looking forward. Though the Federal Reserve action lifted the Fed Funds Rate in December for the first time in almost 10 years, we expect short-term and long-term interest rates to remain low for years to come. As shown in Figure 6, turns in the interest rate cycle are typically a very long process. When the Federal Reserve began lifting short-term rates in 1951, the US 10-year rate was under 2.5%. Yet it took nearly seven years for the 10-year rate to break over 3.0%. Despite historical precedent that long-term yields will languish for a while, economists continue to predict a relatively quick ascension, as shown in Figure 7.
Figure 6: Turns in bond yields can take a very long time... Source: Strategas
US Long-Term Bond Yield – 1938 to 1968 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1938
1941
1944
1947
1950
1953
1956
1959
1962
1965
1968
CAPITAL MARKETS FORECAST 2016
11
Figure 7: ...yet economists still look for higher yields imminently. Source: Strategas
US 10-Year Yield Forecasts among Wall Street Economists, 2016 Year End 18 16
12 # of Forecasts
THE ART & SCIENCE OF INVESTING
14
10 8 6 4 2 0 <2.00%
2.00% - 2.25%
2.25% - 2.50%
2.50% - 2.75%
2.75% - 3.00% 3.00% - 3.25%
3.25% - 3.50%
>3.50%
We now expect a slower trajectory for interest rate increases. This will dampen bond returns versus our prior expectations. We extended the timeline for normalization of the Fed Funds Rate when compared with projections in the 2015 Capital Markets Forecast, as depicted in Figures 8 and 9. Though the Federal Reserve did follow through on its intent to raise interest rates in December, we are not confident it will match the “dot plot” of projected quarterly 25 basis point increases over the next year. For starters, there is In the face of additional interest rate hikes, compelling evidence5 that the current natural interest rate is close to zero; as such, we find it unlikely the Federal Reserve deflation may actually exacerbate rather will deviate too far from this threshold. Secondly, the Fed than improve, causing the Federal Reserve may be underestimating the impact of the initial rate hike on the wave of deflation we have seen to date, as exhibited by to slow down the pace of rate hikes. the action in the global commodity complex. In the face of additional interest rate hikes, deflation may actually exacerbate rather than improve, causing the Federal Reserve to slow down the pace of rate hikes. While a quicker liftoff trajectory would make for higher projected bond returns, an extended interest rate timeline also means increased reinvestment risk. Though we expect Safe to continue to be a shock absorber during sudden equity market volatility, it may be less so going forward. As a result, we may examine alternative sources of alpha and yield that the Safe building block secondarily attempts to achieve during these periods.
Laubach, Thomas, John C. Williams. “Measuring the Natural Rate of Interest Redux.” Working Paper, 2015-16. Federal Reserve Bank of San Francisco.
5
12
CAPITAL MARKETS
FORECAST 2016 Figure 8: The path to higher rates is likely very slow and methodical... Source: Factset and Balentine
Federal Funds Rate Projec on 20.0 17.5 15.0 Even with December’s 25 bps rate hike, we now project a slower path for Fed Funds Rate hikes than we projected a year ago.
12.5 10.0 7.5 5.0 2.5
Actual
2016 Projec on
2015 Projec on
2022
2020
2016 2018
2014
2012
2010
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0.0 2015 and 2016 Projec on
Figure 9: ...as the new Fed Funds Rate trajectory will lag through 2018 but will increasingly catch up with the old trajectory during 2019-2022. Source: Factset and Balentine
Fed Funds Rate Trajectory Projec on (%) 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0
2015
2016
2017
2018
2019
2020
2016 CMF
2015 CMF
2015 CMF and 2016 Cmf
2021
2022
2023
Difference
CAPITAL MARKETS FORECAST 2016
13
THE ART & SCIENCE OF INVESTING
Projected equity market returns remain paltry, with slightly improved returns internationally offsetting weaker returns domestically. We look to international markets for a greater contribution to the success of our Market Risk building block, as we did in our 2015 Capital Markets Forecast. Two notable shifts during the past year further favor our forecast for international equities: 1) real US dividend growth is now projected to be at 1.9% versus 2.1% a year ago and 2) the valuation adjustment of international equities is now expected to be higher at 2.0% versus 1.6% in 2015.6 Moreover, we see the international opportunity set as more selective than we did in 2015. So while we expect more overall out of international equities, it will be even more of a challenge to make sure we are invested in the right spots. As a result, we may need to increase our Art-based7 implementations in order to generate more alpha in the building block, as we did with our Japan allocation throughout 2015. We continue to emphasize the importance of structural reform. All central banks can attempt is to buy time while economies recover; however, regions like Japan that are making genuine attempts to reform government, regulation, and corporate governance are poised to grow and capture market share when the world economy turns a corner. Those who do not, notably the peripheral European countries, likely will be left behind.
We look to international markets for a greater contribution to the success of our
Market Risk building block,
as we did in our
2015 Capital
Markets Forecast.
The risks and meager projected returns for public markets underscore the importance of both Manager Skill and Private Capital. We remain concerned that risks to valuations (in both fixed income and equity markets) and projected dividend growth (in equity markets) make for challenging returns looking forward. As we have noted in the past, the starting valuation of an asset is a large predictor of the asset’s future returns, which is illustrated in more depth in Figure 10. Because current equity valuations are so stretched (Figure 11), forward-looking returns in public markets are likely to be muted. Historically, equities and bonds have had an inverse relationship, meaning when one asset class was up, the other was down. While real yields on equities and bonds in isolation have been lower than they are currently, this inverse relationship allowed for an investment alternative between the two. Now, however, we are in relatively unprecedented times. 6
Please refer to the Appendix for our numbers. Balentine takes an “art and science” approach to investing, in which the “Science” component represents the application of our tactical allocation models in the Safe and Market Risk building blocks. “Art” themes combine objective fact and subjective intuition to capture further opportunities for client portfolios. Art themes must have a stated investment thesis and decisive indicators we are watching to exit the allocation.
7
14
CAPITAL MARKETS
FORECAST 2016 Figure 10: Elevated valuations traditionally make for poor investing opportunities, thus boding poorly for projected returns. Source: AQR Realized Real Equity Returns by Starting Shiller P/E for U.S. Equities January 1926 – December 2014
Starting P/E
Average Realized
Worst Realized
Best Realized
High
10-Yr Return
10-Yr Return
10-Yr Return
Decile
Low
1
5.6
9.6
10.5%
3.9%
19.0%
2
9.6
10.9
11.5%
3.9%
19.1%
3
10.9
12.0
10.9%
3.2%
15.9%
4
12.0
13.8
9.3%
1.1%
15.0%
5
13.8
15.8
8.6%
-1.0%
16.3%
6
15.8
17.5
5.8%
-3.9%
16.3%
7
17.5
19.4
5.6%
-3.6%
14.8%
8
19.4
21.5
4.0%
-3.2%
10.2%
9
21.5
25.7
1.1%
-4.4%
7.6%
10
25.7
44.2
0.8%
-5.9%
6.2%
Figure 11: Equity valuations are stretched. Source: Robert Shiller
Cyclically Adjusted PE
50
200
45 At a CAPE of ~26, equity markets are more expensive than they have been outside of the dot com bubble, the bubble that preceded the Great Depression and the housing crash.
40 35
1929
30 1901
1966
25 15 10
2009
5 1982
2.5 1921 0 1860
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1980
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2020
CAPITAL MARKETS FORECAST 2016
15
Figure 12: Joint valuation in equity and fixed income markets is at historic highs. Source: AQR
US Equity and Bond Real Yields January 1900 – November 2015
Equity Real Yield
Bond Real Yield
20% Absolute: Stocks inexpensive, bonds inexpensive Rela ve: Neither expensive rela ve to each other
THE ART & SCIENCE OF INVESTING
18%
16
Absolute: Stocks inexpensive, bonds inexpensive Rela ve: Stocks more expensive than bonds
16%
Absolute: Stocks inexpensive, bonds inexpensive Rela ve: Bonds more expensive than stocks
14% 12%
Absolute: Stocks inexpensive, bonds inexpensive Rela ve: Neither expensive rela ve to each other
10% 8% 6% 4% 2% 0% -2% 1900
1920
1940
1960
1980
2000
2015
Putting together the equity and bond real yields into a traditional 60/40 portfolio (Figure 12), the joint expected return is lower than it has been at any time since January 1900. Thus, as can be seen in Figure 13, the ability for our strategies to achieve their objectives absent contributions from Manager Skill and Private Capital is more challenging that it has been in the past.
CAPITAL MARKETS
FORECAST 2016 Figure 13: The ability of Public Markets strategies to achieve portfolio objectives remains challenging. More savings will likely be necessary to achieve the desired goals. Source: Balentine
2016 GOALS
RISK
CPI +1%
CPI +2%
CPI +3%
CPI +4%
CPI +5%
Risk of Loss in 1 Year
Public Markets Aggressive
82.1%
77.8%
72.5%
65.8%
59.8%
27.4%
15.5%
7.4%
Public Markets Growth
81.2%
76.0%
68.9%
61.8%
54.7%
26.9%
15.0%
6.5%
Public Markets Balanced
80.3%
73.0%
63.1%
54.4%
44.5%
25.1%
13.2%
4.9%
Public Markets Conservative
77.8%
65.2%
53.2%
38.9%
26.4%
23.0%
10.6%
2.9%
Public Markets Aggressive w/ Private Capital
88.4%
83.6%
78.8%
72.8%
65.1%
23.6%
11.3%
3.1%
Public Markets Growth w/ Private Capital
88.0%
83.4%
77.0%
69.2%
60.5%
23.2%
10.8%
2.8%
Public Markets Balanced w/ Private Capital
88.6%
81.8%
73.7%
62.6%
53.0%
19.6%
8.0%
1.4%
Public Markets Conservative w/ Private Capital
89.5%
80.8%
69.1%
55.6%
41.3%
17.0%
5.5%
0.7%
Fully Diversified Aggressive
83.5%
78.5%
72.3%
64.4%
57.8%
25.6%
13.6%
5.3%
Fully Diversified Growth
84.9%
78.8%
71.3%
62.0%
53.7%
23.3%
11.1%
3.2%
Fully Diversified Balanced
84.5%
75.9%
63.2%
51.7%
38.3%
20.2%
8.5%
1.5%
Fully Diversified Conservative
83.9%
68.3%
49.5%
29.7%
14.2%
15.2%
4.0%
0.5%
Fully Diversified Aggressive w/ Private Capital
89.5%
84.6%
79.3%
72.1%
63.3%
21.4%
9.7%
2.1%
Fully Diversified Growth w/ Private Capital
91.5%
86.3%
79.6%
70.9%
60.6%
18.7%
6.8%
1.1%
Fully Diversified Balanced w/ Private Capital
92.8%
86.2%
77.0%
63.5%
50.9%
15.3%
5.0%
0.5%
Fully Diversified Conservative w/ Private Capital
94.4%
85.8%
72.8%
54.9%
36.2%
11.7%
2.3%
0.2%
60% ACWI / 40% Barclays Aggregate
66.3%
57.0%
47.7%
37.5%
28.0%
30.3%
19.8%
11.2%
Strategy
Risk of Loss in 3 Years
Risk of Loss in 7 Years
In 2015, we rebalanced the Manager Skill building block to take advantage of systematic, rules-based discipline in lieu of individual manager risk. We believe this is a more effective way to achieve the building block’s targeted return and volatility of 5% and 7%, respectively. Additionally, we are implementing strategies such as reinsurance and bank lending, much of which come in the form of yield. Though there continues to be modest tax inefficiency within Manager Skill, the benefits to the portfolio should offset tax consequences. Low-return environments often lead investors down a dangerous path of “chasing yield” without proper knowledge of the risks involved. This can lead to permanent impairment of capital. Investors must take intentional risk in unconventional ways to boost income and returns while paying careful attention to the risks involved. We believe our investments in reinsurance and direct lending will achieve the required results under appropriate levels of risk by allowing us to access the risk premia embedded in these investments.
CAPITAL MARKETS FORECAST 2016
17
THE ART & SCIENCE OF INVESTING
Reinsurance offers returns driven by sustainable sources via collecting insurance premiums in exchange for taking on specific risks. This acts as a great diversifier given the drivers behind the risks insured are well insulated from the drivers of equity markets and are not accessible in the public markets. Similar to reinsurance, direct lending allows us to take calculated risks on entities that need funds but are unable to access them due to lending voids resulting from onerous bank regulations. Investors agree to lock up their money in exchange for exposure to a myriad of lending streams once only available to banks. The Private Capital building block is perhaps a larger factor now than in the past, as concerns abound regarding dwindling expected returns in public markets. To that point, we have structured Private Capital among private equity and real assets that capitalize on both the illiquidity premium and on proactive, calculated risks that provide strong diversification and a more compelling risk-reward tradeoff. These are not funds of funds, but rather single funds with a sharper implementation. Though the risks assumed for the potential rewards are compelling, they are not free lunches. These assets can exhibit sharp drawdowns, and investors need to be prepared to use those drawdowns to their advantage, adding to these investments during times of distress, not liquidating them. Given the permanent impairment of returns from central bank policies, our Objectives ranging from inflation+1% to inflation+4% are realistic hurdles for our strategies. Much of our outlook is predicated on the world continuing to deleverage on the back of the housing bubble that peaked almost 10 years ago. While government deficit spending across the globe has driven government debt higher, much of this was to offset private deleveraging. These cycles typically take a long time to play out, and markets tend to produce relatively meager returns, as exhibited in Figure 14. Figure 14: Total real returns across all public market asset classes tend to lag during cycles of below-average credit growth or deleveraging. Source: Aswath Damodaran, Stern School of Business at New York University
US Annual Realized Returns Stocks
Bills
Bonds
1928-1981
8.6%
2.8%
2.8%
1981-2007
12.2%
5.5%
9.3%
2008-2015
6.4%
0.2%
4.3%
In his book Stocks for the Long Run, Jeremy Siegel insinuates that stocks are priced to deliver inflation+6% over the long haul. This figure is too high for our purposes for two notable reasons. First, we believe his 100-year timeframe is inappropriate for our seven-year Capital Markets Forecast; our clients do not have the luxury of looking at time horizons that long. Additionally, we are in the midst of a deleveraging cycle which tends to produce returns below those of “the long run� (Figure 13). Another important aspect to Siegel’s figure is that his study ended during the internet bubble, when stocks were priced in excess of what fundamentals would merit and when the natural real interest rate was closer to 2% in contrast to the current 0% that has so impaired looking-forward returns. We believe inflation+4% is a more appropriate target through full market cycles, a goal we now believe to be more of a challenge owing to central bank policies. One unintended consequence of these policies has been to bring forward returns across many asset classes. A second consequence is the suppression of equity risk premia. These in combination have driven investors to aim for higher rates of return than our Objectives of Inflation+1% to Inflation+4% at a time when markets are not priced to deliver such lofty returns. As shown in Figure 15, asset classes poised to deliver higher yields have, in fact, taken on risk not commensurate with the return gained from the higher yield.
18
CAPITAL MARKETS
FORECAST 2016 Figure 15: Over the last five years, investors stretching for yield and returns in the equity and fixed income spaces, respectively, MLPs and High-Yield Debt have taken on disproportionate risk. Source: Factset
MSCI ACWI 6.1%
1.8%
13.8%
20.1%
0.44
0.09
Return Risk Sharpe
Barclays US Aggregate Index
Alerian MLP Index
High Yield Bonds
Return
3.3%
3.8%
Risk
3.3%
7.9%
Sharpe
1.01
0.48
In contrast with the excessive risks assumed by others, Balentine strategies are designed to take on the appropriate risk level for a client’s risk tolerance while maximizing return. As shown in the Appendix, our strategies are poised to deliver between 5-8%, which is inclusive of: 1) 200 basis points (bps) of excess return over the MSCI ACWI within Market Risk, 2) 50 bps of excess return over the Barclays Aggregate Index within Safe, and 3) additional excess return from tactical rebalancing across building blocks. Our Fully Diversified Balanced portfolio has traditionally exceeded the traditional 60/40 portfolio over full market cycles on both a pure returns and risk-adjusted basis (Figures 16 and 17). Figure 16: Balentine Fully Diversified Balanced versus the traditional 60/40 portfolio. Source: Balentine
Fully Diversified Strategy – Balanced vs. 60/40 Por olio
25%
2003
20%
2009
2009
2003 15% 2006 10%
2006
Return
5%
2004 2007 2005 2014 2005
0%
2013
2004 2012
2012 2010
2010
2013 2014 2007 2015
2015
2000
2011
2011 -5%
2000 2001
2002
-10%
2001
2002
-15% Balen ne diversified strategies have consistently been more efficient compared with the tradi onal 60/40 por olio.
-20%
2008
2008
-25% 3%
5%
7%
9%
11%
13%
15%
Vola lity Fully Diversified Strategy – Balanced
60/40 Blend: All-Cap World/US Aggregated Bond
C A P I T A L M A R K E T S F O R E C A S T 2 0 1 619
19
Fully Diversified Strategy - Balanced
THE ART & SCIENCE OF INVESTING
Return
20
Volatility
Difference
Sharpe
Return
Volatility
Sharpe
2015
1.0%
6.1%
0.17
2015
130bp
(101bp)
0.21
2014
3.6%
4.7%
0.76
2014
(299bp)
(71bp)
(0.45)
2013
8.3%
5.6%
1.50
2013
(409bp)
(148bp)
(0.27)
2012
10.6%
6.2%
1.72
2012
(232bp)
(211bp)
0.16
2011
-0.4%
8.5%
-0.05
2011
(83bp)
(199bp)
(0.09)
2010
10.2%
8.0%
1.28
2010
105bp
(392bp)
0.51
2009
(85bp)
(339bp)
0.36
2009
18.4%
10.5%
1.74
2008
-20.9%
12.7%
-1.65
2008
128bp
(62bp)
0.02
2007
6.8%
4.6%
1.47
2007
179bp
(99bp)
0.58
2006
10.9%
3.5%
3.09
2006
6bp
(1bp)
0.03
2005
6.1%
4.5%
1.35
2005
252bp
(12bp)
0.57
2004
12.2%
6.3%
1.95
2004
462bp
157bp
0.33
2003
20.4%
6.4%
3.18
2003
195bp
(48bp)
0.50
2002
-5.8%
8.6%
-0.67
2002
466bp
(262bp)
0.26
2001
-3.3%
10.7%
-0.31
2001
139bp
(86bp)
0.10
2000
1.6%
9.4%
0.17
2000
404bp
(146bp)
0.40
2000-2015
4.5%
7.9%
0.57
2000-2015
93bp
(137bp)
0.18
3/2000-10/2007
6.4%
7.3%
0.88
3/2000-10/2007
223bp
(82bp)
0.37
3/2003-3/2009
4.7%
8.1%
0.57
3/2003-3/2009
230bp
(63bp)
0.30
60/40 Blend: All-Cap World/U.S. Aggregate Bond Return 2015
-0.3%
Volatility 7.1%
Sharpe -0.04
2014
6.5%
5.4%
1.21
2013
12.4%
7.0%
1.77
2012
12.9%
8.3%
1.57
2011
0.4%
10.5%
0.04
2010
9.1%
11.9%
0.77
2009
19.2%
13.9%
1.38
2008
-22.2%
13.3%
-1.67
2007
5.0%
5.6%
0.89
2006
10.8%
3.5%
3.06
2005
3.6%
4.6%
0.77
2004
7.6%
4.7%
1.61
2003
18.5%
6.9%
2.67
2002
-10.4%
11.2%
-0.93
2001
-4.7%
11.6%
-0.41
2000
-2.4%
10.9%
-0.22
2000-2015
3.6%
9.3%
0.39
3/2000-10/2007
4.1%
8.1%
0.51
3/2003-3/2009
2.4%
8.7%
0.27
The Balentine Fully Diversified Balanced portfolio has consistently delivered superior returns with less risk than traditional 60/40 portfolio.
Figure 17: Balentine Balanced portfolio versus the traditional 60/40. Source: Balentine
CAPITAL MARKETS
CREATIVE OPPORTUNITIES
FORECAST 2016
OUTLOOK ON COMMODITIES AND COMMODITIES-RELATED INVESTMENTS
A
cross the investment landscape in Market Risk, the opportunity top of mind for many investors is the potential for a rebound in commodity prices, most notably oil, and related investments such as Emerging Markets. As first communicated in early 2015, based on historical precedent, there is plenty
of opportunity to capture the upside after these severe declines without rushing in to try and catch a bottom. Rather than lasting momentarily (i.e., a “V” bottom), these bottoms tend to endure, as second-order and third-order ramifications from the price declines take time to manifest. To that end, our thoughts regarding investments in commodities, oil, and commodity-related asset classes over the next 12 months are as follows: 1. Oil, commodities, and commodity-related asset classes may be at a tradeable bottom. Despite the media frenzy, we first resisted calling a bottom in the oil price of the low put during March of 2015, citing our thesis that market did not yet understand the underlying oversupply story. Our intuition proved correct as inventory levels week after week continued to surprise the consensus to the upside. In contrast, today everyone knows the world is inundated with oil. We are now seeing predictions for $20/barrel oil, and the International Energy Agency has essentially thrown in the towel on a recovery in 2016. The story for other commodities is similar, as bear markets grind on and sentiment continues to weaken. We do not dismiss the possibility that commodities, oil, and oil-related equities could rally, as assets tend to have sharp rallies when sentiment and technicals (Figures 18 and 19) get overly bearish. However, the key word for us is “tradeable.” History shows that assets do not decline directly to their ultimate bottoms but rather arrive there with brief stretches of bullish price action. Oil price action in March was a good example of this, and we could see it again early in 2016.
C A P I T A L M A R K E T S F O R E C A S T 2 0 1 621
21
Crude Oil – WTI 120 110
Figure 18: The bottom in commodities and related areas remains elusive, in our opinion.
THE ART & SCIENCE OF INVESTING
Source: Factset
100 90 80 70 60 50 40 30 1/1/14
7/1/14
1/1/15
7/1/15
1/1/16
Goldman Sachs Commodity Index 700
Calling a bottom in 2015 proved premature...
...yet bottom callers are out again without a clear sign of a bottom. We remaim unconvinced at this point.
600
500
400
300 1/1/14
7/1/14
1/1/15
7/1/15
1/1/16
MSCI Emerging Markets Index 1,200 1,100 1,000 900 800 700 1/1/14
22 22
7/1/14
1/1/15
7/1/15
1/1/16
CAPITAL MARKETS
FORECAST 2016 Figure 19: Oil equities are up against decades-long support. Source: Factset
NYSE Arca Oil & Gas Index
1000
Will the ~30-year trendline hold?
0% 1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2. Oil, commodities, and commodity-related asset classes have likely not yet found their ultimate bottoms. Though the current supply-demand imbalance story is well known at this point, we think the market continues to err on the outlook for the imbalance looking forward. Quite simply, commodity producers will continue to generate supply to gain market share (or not lose, at the very least) in the quest to maintain solvency. While this is by no means exclusive to oil, it may be the best example of this competitive dynamic, also known as the prisoner’s dilemma, as Figure 20 illustrates.8 Say we have two oil producers, both of whom are suffering revenue and profit erosion as the price of oil declines. In a world where price fixing is either not allowed (per US government regulation) or not possible (as OPEC is far less effective than in the past), Producer A and Producer B can choose to either cut oil production or maintain it.
8
Though our example assumes a two-competitor industry, it works similarly in a multi-producer industry.
C A P I T A L M A R K E T S F O R E C A S T 2 0 1 623
23
Figure 20: A classic prisoner’s dilemma in the oil producer space should keep supply flowing for quite some time. Source: Balentine Producer A cuts production • Price of oil rises
• Price of oil rises
Producer B does,
• Producer A maintains market share
• Producer A gains market share
Producer A is better
• Producer B maintains market share
• Producer B loses market share
• P rice of oil rises
• P rice of oil declines
• P roducer A loses market share
• P roducer A maintains market share
• P roducer B gains market share
• P roducer B maintains market share
THE ART & SCIENCE OF INVESTING
Regardless of what
24 24
Producer A maintains production
served by maintaining production.
Producer B cuts production
Producer B maintains production
Regardless of what Producer A does, Producer B is better served by maintaining production. Regardless of what the competition does, it is in each producer’s best interest to maintain production. However, by acting in their individual best interests, the producers actually do what is in their joint worst interests. We cannot underscore how crucial it is to understand this point. Each producer will keep pumping to gain market share, prolonging the price declines, which will perpetuate the need to pump further and keep supply at excess levels. Only when producers lose their motivation to produce (typically via merger/acquisition or bankruptcy) will this dynamic cease, at which point the bear markets in oil-related and commodity-related investments may run their course. Until we see consolidation in the space amongst the producers with better balance sheets (i.e., without solvency concerns to allay), the supply of commodities will likely keep flowing, thus capping the potential return on commodity-related asset classes. Emerging Markets are also heavily influenced by commodities, owing to the abundance of commodity-exporting nations within the group. While Emerging Markets tend to trade at a premium to developed markets, they actually should trade at a discount because they are riskier. The current valuation is inexpensive by historical standards. However, given that historical valuations may reflect an artificially-elevated hurdle, the key question is whether the current prices reflect enough of a discount to merit inclusion in portfolios. We believe this may be the case for some non-oil-exporting Emerging Markets and may look at them as a potential tactical opportunity in 2016, thus continuing on our theme of selectivity.
CAPITAL MARKETS
FORECAST 2016
PRIVATE CAPITAL ROADMAP THE CASE FOR PRIVATE CAPITAL
As we have discussed at length, public market returns face strong headwinds going forward. Valuations in equities and bonds are near all-time highs which create difficulties for clients who seek real return. It is therefore our job to bridge this gap, taking intentional risks in portfolios to smartly increase the expected return for clients. One way Balentine aims to achieve this is through a diverse allocation to private capital. We do not recommend an investment in private capital to simply access the illiquidity premium; instead, we accept the illiquid nature of these investments as a necessary prerequisite to access what we consider unique exposure with diverse ways of adding value. This advantage should stand alone and not just be a product of financial engineering. This advantage and exposure is captured in two ways: 1. Return source diversification 2. Medium of investment Return source diversification refers to the risks a portfolio is exposed to, as well as the portion of the return derived from capital gains versus yield. Public markets typically generate returns through exposure to the equity risk premium for stocks and credit and interest rate risk for bonds. These assets also provide the capital gains (stocks and high yield bonds) and yield (investment grade bonds and dividend-paying stocks) which make up the total return. Exposure to private markets increases both the number of risk premiums and the traditional sources of total return. An example of this is a private investment in reinsurance. The insurance risk premium provides a return for those willing to accept the risk of loss for the steady income of premiums. Diversifying the make-up of total return also becomes much more impactful within private markets. For example, when investing in real estate, the spectrum ranges from core, which are trophy buildings in gateway markets, to opportunistic, which can be half-vacant neighborhoods needing a fair share of work. While both are investments in real estate, the different risks result in vastly different return profiles. Core investments can return 6-8% a year with over half of the return coming from yield. Opportunistic investments can return 12-15%, with the majority coming from capital appreciation. These different drivers and sources of return not commonly found in public markets provide the sustainable advantage we seek in private capital. A second advantage comes from the medium of investment -– how and where the manager is able to invest. Typical public market investments include access to investment grade and high yield bonds as well as the public equity of a company. Private placements can invest up and down the capital structure of a firm, as shown in Figure 21:
Figure 21: Capital structure options for a private equity investor. Source: Balentine
Public Equity
Private Equity
Public Markets Investor
Senior Debt
Private Markets Investor
Junior Debt
Mezzanine Debt
C A P I T A L M A R K E T S F O R E C A S T 2 0 1 625
25
THE ART & SCIENCE OF INVESTING
This allows a manager to be more creative in adding value. One example of a creative way of adding value is a debt manager who invested in senior debt of a fledgling company and took control of the company in bankruptcy. After restructuring the company, the manager could then lead a buyout of the firm and become a holder of its junior debt, leveraging their in-depth knowledge of the company. This variety of exposure is made possible by accepting the illiquid nature of a private capital investment.
26 26
THE RISKS OF PRIVATE CAPITAL There is no shortage of risks present when investing in private capital. While each investment has its own idiosyncratic risks, four macro risks affect private capital as a whole. Understanding and planning for these risks are key to successfully implementing private capital.
Risk Illiquid nature of investment will put strain on client
Consideration • Ensure spending needs are in cash or liquid investments. • Match the liquidity profile of the investment with the profile of the client. Those with shorter time horizons need to have shorter lock up investments. • Portfolio construction is key. Building up a more liquid yielding allocation will help fund the rest of the program, requiring less upfront capital.
Investing in private capital may entail losing money
• While this is true in all asset classes, the number of esoteric investments with less stringent regulation is much higher in private capital. It is imperative to allocate only to investments that have a clear sustainable advantage over public markets. • Approach private capital as a long-term strategic allocation, not tactical. Short-term losses should not affect long-term plans.
The use of leverage can exacerbate the outcomes
• Uncover the true advantage of the investment and ensure it can stand alone before any leverage is applied. Varying amounts of leverage are acceptable in the presence of a truly sustainable advantage.
Misalignment of the manager and the investor can adversely affect outcomes
• Choose managers that have taken steps to align themselves with investor interests through lower fees, shorter lock ups, and quicker investment periods.
CAPITAL MARKETS
FORECAST 2016 THE IMPLEMENTATION OF PRIVATE CAPITAL Accessing private capital depends greatly on asset level and should balance three critical aspects: 1. Access 2. Diversification 3. Fees The vehicle for access can be a fund of funds, direct fund, co-investment, or a direct investment. It is important to strike a balance between the asset level, vehicle, and investor intentions. The higher volatility in natural resources and infrastructure due to geological and political risks lend the advantage to a fund of funds structure. On the other hand, direct investment in private equity can lend itself towards impact investing, which puts money to work for more than just a return and funds direct interests of the investor. A fund of funds can take a low ticket ($250,000) and invest across 10-15 top tier managers. For those with less than $10 million to allocate to private capital, this approach provides a good balance between access and diversification in exchange for the extra level of fees paid. When private capital assets reach $10 million, the conversation around direct investing can begin. We recommend 8-10 investments to reach a comfortable level of diversification in direct investing. Since direct investing typically has a higher ticket ($500,000 or more), roughly $4-5 million is needed in private equity alone to replicate the diversification of a fund of funds. While direct investing saves a layer of fees, it is important to ensure it is balanced with appropriate access, as many top tier managers are typically oversubscribed and therefore only available through fund of funds structures. Balancing access, diversification, and fees along with investor intentions should lead to correct implementation of private capital.
BUILDING A PRIVATE CAPITAL ALLOCATION We recommend allocating 20% of a portfolio to Private Capital as a starting point which, going forward, will be funded pro rata across all building blocks. The final allocation can be greater or less than 20%, given the following four considerations: 1. Liquidity profile 2. Type and amount of assets 3. Need for return (yield versus capital appreciation) 4. Risk profile These will ultimately drive the size and makeup of the allocation and how it is built up over time. A portfolio with large spending requirements on a yearly basis should have a lower allocation to private capital, and it should be tilted toward investments with higher liquidity. Conversely, those with long time horizons should leverage the lack of liquidity needs and invest more in private capital.
C A P I T A L M A R K E T S F O R E C A S T 2 0 1 627
27
Six investments in particular offer the return enhancement and diversification needed to accept the illiquid nature of these investments. They can be categorized into private equity and real assets: Private Equity 1. Venture Capital 2. Leveraged Buyouts
THE ART & SCIENCE OF INVESTING
3. Special Situations / Direct Deals Real Assets 1. Real Estate 2. Natural Resources 3. Infrastructure In the coming months, we will populate these investments with managers which we believe best access the sustainable advantage over public markets we seek in these asset classes. These investments, coupled with the ones we are making in our Manager Skill building block, offer creative solutions to bridge the gap between the returns offered in today’s market and what clients need.
THE EUROPEAN REFUGEE CRISIS-OPPORTUNITY OR RISK?
N
ewspaper headlines shout the story: “Mass migration crisis may yet get worse” (New York Times 11/02/2015) and “One million more Syrians may be heading for Europe (Daily Mail, 10/30/2015). Despite the near-apocalyptic tone of the press, the actual situation is not as unique as suggested. The
humanitarian crisis is heart wrenching; however, we are going to focus on addressing the broader questions of human migration trends, the specific issues facing Europe and what the future might hold, and potential investment implications.
HISTORY OF MASS MIGRATIONS Mass migrations are an integral part of world history. The first migrations involved the movement of humans out of Africa to Europe, Asia, and the Americas thousands of years ago. Like most migrations, these involved people fleeing climate pressures or political conflicts, seeking new opportunities for a better life. Encyclopedia Britannica summarizes the largest migrations as follows: “The map of Europe is the product of several major early migrations involving the Germanic peoples, the Slavs, and the Turks, among others. In the course of 400 years-from the late 16th through the 20th century, the Americas, Australia, Oceania, the northern half of Asia, and parts of Africa were colonized by European migrants. The overseas migration of Europeans during this period totaled about 60 million people. The largest migration in history was the so-called Great Atlantic Migration from Europe to North America, the first major wave of which began in the 1840s with mass movements from Ireland and Germany. In the 1880s a second and larger wave developed from eastern and southern Europe; between 1880 and 1910 some 17 million Europeans entered the United States. The total number of Europeans reaching the United States amounted to 37 million between 1820 and 1980.
28 28
CAPITAL MARKETS
FORECAST 2016 From 1801 to 1914 about 7.5 million migrants moved from European to Asiatic Russia (i.e. Siberia), and between World Wars I and II about 6 million more…. Some 13 million migrants became permanent residents of Western Europe from the 1960s through the ‘80s, and more than 10 million permanent immigrants were admitted legally to the United States in that same period.”
HISTORICAL MIGRATIONS COMPARED TO TODAY How does Europe’s immigrant inflow today compare to the past? There are four stark contrasts today with prior immigrations: 1) the movement is taking place in a comparatively short period of time, 2) underlying economies are weak and deleveraging, 3) the effect of current entitlement programs, and 4) terrorism risk. According to the International Organization for Migration, more than one million refugees entered Europe in 2015. As shown in Figure 22, this is more than double then annual inflow of most prior periods. While past migrations usually were movements from higher density population areas to lower density population areas, today it is the reverse, further heightening the humanitarian aspect of the crisis.
Period
Region
Annual Immigrants
1880-1910
US
566,000
1820-1980
US
120,000
1801-1914
US
66,000
1960-1980
US
333,000
1960-1980
Europe
433,000
Figure 22: Previous historical immigration episodes. Source: Encyclopedia Britannica
As a result, too many refugees in too short a time are overwhelming registration, living, and work opportunities. Many refugees are unskilled and therefore less able to enhance the growth of the economies. Furthermore, given the relatively stagnant European economy, it will be harder to find permanent jobs. With the added fear of terrorists entering countries, there is a potential backlash of immigrants taking jobs, receiving free services, and resulting in higher taxes. The reaction of local people is quite understandable when they feel their livelihood, lifestyle, and life may be threatened.
WHAT IS THE CURRENT SITUATION? According to the UN High Commission for Refugees, 65% of the estimated one million refugees are men. Most come from the Middle East (Syria and Iraq), South Asia (Afghanistan and Pakistan), and Africa (Eritrea and other countries). Refugees earlier in the year were coming by boat, but more recent arrivals have come over land into Northern Europe through Turkey, the Balkans, and Hungary. Despite the large number moving north, over two million remain in Turkey and millions more are waiting to come. Initially, Europe tried to control the flow by requiring registration at the point of entry into a European country. However, the numbers were overwhelming, and Italy, Greece, and Serbia were not able to hold them back. For the refugees, the perceived attraction of Europe was amplified when German Chancellor Angela Merkel said Germany could take one million immigrants. Her open door policy was a charge to the other European countries to send them through to Germany with minimal documentation. This follows the Schengen Convention, which defines an area of Europe without border controls (26 countries in all). Once an individual is in Europe, they can travel anywhere without border checks. C A P I T A L M A R K E T S F O R E C A S T 2 0 1 629
29
HOW HAS EUROPE RESPONDED TO THE FLOOD OF REFUGEES?
THE ART & SCIENCE OF INVESTING
Europe’s response has been mixed. Initial refugees into Greece and Italy were often stranded in poorly-run refugee camps. Greece and Italy were not prepared to handle growing numbers who entered earlier in the year. The rest of Europe became involved when migration moved to the land route through the Balkans. The ability of countries to stop the flow of refugees was lost. When barbed wire fences were erected in Hungary, the refugees moved west and entered through Croatia.
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WHAT IS THE FUTURE? The future for Europe and the refugees could be largely positive, but there are several caveats. In particular, we see four issues and initial concerns: 1. Changing policies on accepting refugees 2. Tightening of border security 3. Political ramifications 4. Prospective costs and benefits Changing policies on accepting refugees. Prior to the Paris attacks in mid-November, Europe had adopted a relocate and resettle policy, including quotas for granting asylum to 164,000 refugees to be spread across Europe, despite an influx of one million people. In 2014 only 184,665 applications to the EU were approved out of 570,000. It is not clear what happens to the migrants who do not receive approval. The intent is to return them to their country of origin or a receptive country such as Turkey. But the country of origin has to be secure, and right now Syria and Iraq are not. Turkey already accommodates over two million refugees and needs to be persuaded by Europe to take more. Turkey has priced their persuasion as a cash payment of $3.4 billion, visa free travel for its citizens in Europe, and acceleration of talks on Turkey to join the European Union. Tightening of border security. Rules in the Schengen Zone prevent countries from systematically vetting European citizens traveling across country borders. But the Paris attacks threw these modest controls out the window, and security has been sharply tightened. Now every traveler coming to Europe will have their name checked against an anti-terror watch list and criminal and security databases. These changes will certainly make travel to Europe more stressful. It is not clear, however, that the new rules can effectively vet the large number of refugees. Political ramifications. Europe is turning more conservative with regard to immigration. In Sweden the far right party has made significant gains in the polls. France’s National Front party headed by Marine Le Pen seems poised to see a large increase in political fortunes. Even Germany is experiencing pushback to its open door policy, particularly in Munich where many refugees first arrived. The UK vote scheduled for 2017 to consider remaining in the EU may be more tilted toward a “no.” It is too early to assess what the shift to the right may mean for Europe’s economy. The prospect of a backlash from the immigrant communities similar to what is happening in Israel also seems quite possible.
CAPITAL MARKETS
FORECAST 2016 Prospective costs and benefits. Germany has estimated that it costs 12,000 Euros per year to support a refugee before they are assimilated. Assuming one million refugees and with Europe’s GDP of ~$18.5 trillion (€17.0 trillion), that amounts to about ~0.1% of GDP and ~2% of the population. A study in the Organization for Economic Cooperation and Development’s International Migration Outlook concluded that migration is “neither a significant gain nor drain for the public purse.” A number of recent studies on the economic impact of migration give evidence that large inflows of immigrants are actually beneficial to economies, not detrimental. These studies do not tell the whole story, however, and the future may not be quite as rosy. So far Germany’s “public purse” seems able to handle the costs. But there are increasing costs to the private sector, including increased security and instruction costs to an untrained work force. Lebanon, Turkey, and Jordan have significant migrant populations and are showing solid economic growth. The monetary support provided to migrants is immediately spent and may produce short-term benefits to an economy, although studies have shown some displacement of unskilled and part-time labor. It is too early to really know how much of an impact there will be on economic growth. Historically, the long-term benefits of migrants are even greater for economies with shrinking work forces, such as Europe. The unknown risk is how many refugees are still to come and whether it will be a flood or a steady flow. Moreover, will this influx have inflationary effects on local economies through greater demand for goods or, conversely, deflationary effects as excess capacity overwhelms any potential gains in aggregate demand? Our final question is this: “How does this crisis impact markets?” It is too early to know. We can see the case that shows Europe suffering from further stagnation to one where an orderly integration of refugees is relatively beneficial. Another caveat is that a substantial increase in homegrown terrorist activity could impact consumer confidence and market psychology. To that end, following on our previously-articulated theme, it will continue to pay to be selective in our investment choices. While we currently maintain broad European exposure as part of targeted exposure to developed International equities, we may look to target more specific areas within Europe as we see how immigration ramifications play out.
C A P I T A L M A R K E T S F O R E C A S T 2 0 1 631
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APPENDIX EXPECTED RETURN AND RISK ASSUMPTIONS ACROSS BUILDING BLOCKS
THE ART & SCIENCE OF INVESTING
Safe
32
Manager Skill
Private Capital
Expected Return
2.7%
Market Risk 8.3%
5.0%
10.5%
Expected Volatility
3.8%
16.3%
7.0%
15.0%
CORRELATION ASSUMPTIONS ACROSS BUILDING BLOCKS Safe
Market Risk
Manager Skill
Private Capital
Safe
1.0
Market Risk
0.0
0.0
0.0
0.0
1.0
-0.2
0.5
Manager Skill
0.0
-0.2
1.0
-0.2
Private Capital
0.0
0.5
-0.2
1.0
DRAWDOWN TARGETS Public Market
Fully Diversified
Aggressive
25%
20%
Growth
20%
15%
Balanced
15%
10%
Conservative
10%
5%
CAPITAL MARKETS
FORECAST 2016
BUILDING BLOCK STRATEGIC WEIGHTS Fully Diversified Safe
Aggressive
Growth
Balanced
Conservative
0.0%
5.0%
25.0%
45.0%
Market Risk
85.0%
70.0%
50.0%
30.0%
Manager Skill
15.0%
25.0%
25.0%
25.0%
Private Capital
0.0%
0.0%
0.0%
0.0%
100.0%
100.0%
100.0%
100.0%
7.8%
7.2%
6.0%
4.9%
13.7%
11.2%
8.0%
5.1%
Expected Return Expected Volatility Expected Yield Expected Drawdown
2.1%
1.8%
1.9%
1.9%
-19.5%
-15.2%
-10.0%
-5.4%
Fully Diversified with Private Capital Safe
Aggressive
Growth
Balanced
Conservative
0.0%
5.0%
20.0%
35.0%
Market Risk
70.0%
55.0%
40.0%
25.0%
Manager Skill
10.0%
20.0%
20.0%
20.0%
Private Capital
20.0%
20.0%
20.0%
20.0%
100.0%
100.0%
100.0%
100.0%
Expected Return Expected Volatility Expected Yield Expected Drawdown
8.5%
7.9%
7.0%
6.2%
12.2%
9.8%
7.5%
5.5%
1.7%
1.5%
1.5%
1.5%
-15.9%
-11.6%
-8.0%
-4.8%
Public Markets Aggressive
Growth
Balanced
Conservative
0.0%
15.0%
35.0%
55.0%
100.0%
85.0%
65.0%
45.0%
Manager Skill
0.0%
0.0%
0.0%
0.0%
Private Capital
0.0%
0.0%
0.0%
0.0%
100.0%
100.0%
100.0%
100.0%
Safe Market Risk
Expected Return Expected Volatility Expected Yield Expected Drawdown
8.3%
7.4%
6.3%
5.1%
16.3%
13.9%
10.7%
7.6%
2.5%
2.5%
2.5%
2.5%
-24.3%
-20.3%
-15.1%
-10.1%
Public Markets with Private Capital Aggressive Safe Market Risk Manager Skill Private Capital
Expected Return Expected Volatility Expected Yield Expected Drawdown
Growth
Balanced
Conservative
0.0%
10.0%
30.0%
45.0%
80.0%
70.0%
50.0%
35.0%
0.0%
0.0%
0.0%
0.0%
20.0%
20.0%
20.0%
20.0%
100.0%
100.0%
100.0%
100.0%
8.9%
8.3%
7.1%
6.3%
13.9%
12.4%
9.3%
7.2%
2.0%
2.0%
2.0%
2.0%
-19.0%
-16.4%
-11.5%
-8.1%
CAPITAL MARKETS FORECAST 2016
33
APPENDIX BUILDING BLOCK RANGES Fully Diversified (%) Aggressive Minimum Safe Market Risk
THE ART & SCIENCE OF INVESTING
Manager Skill
Growth Maximum
Minimum
Strategic
Maximum
0%
0%
60%
0%
5%
65%
40%
85%
100%
25%
70%
85%
0%
15%
50%
10%
25%
50%
Expected Return Expected Drawdown
7.8%
7.2%
-19.5%
-15.2%
Balanced
Conservative
Minimum
Strategic
Maximum
Minimum
Strategic
Maximum
Safe
0%
25%
85%
20%
45%
90%
Market Risk
5%
50%
70%
0%
30%
50%
10%
25%
50%
10%
25%
50%
Manager Skill Expected Return Expected Drawdown
6.0%
4.9%
-10.0%
-5.4%
Public Markets (%) Aggressive Safe Market Risk
Growth
Minimum
Strategic
Maximum
Minimum
Strategic
Maximum
0%
0%
35%
5%
15%
55%
65%
100%
100%
45%
85%
95%
Expected Return Expected Drawdown
7.8%
7.4%
-24.3%
-20.3%
Balanced
Conservative
Minimum
Strategic
Maximum
Minimum
Strategic
Maximum
Safe
15%
35%
70%
35%
55%
90%
Market Risk
30%
65%
85%
10%
45%
65%
Expected Return Expected Drawdown
34
Strategic
6.3%
5.1%
-15.1%
-10.1%
CAPITAL MARKETS
FORECAST 2016
PRISM INPUTS Liquid & Safe Building Blocks Annualized Return
Yield to Maturity
Duration (Years)
Price Impact of 2% Rate
Nominal
Real
2015 CMF
2014 CMF
Risk
US Treasury: 7-10 Years
2.2%
7.7
15.5%
1.3%
-0.8%
1.5%
1.8%
7.5%
US Municipal (Tax Equivalent)
2.4%
6.2
12.4%
1.9%
0.2%
2.1%
3.5%
4.2%
US Aggregate Benchmark
(Barclays US Aggregate Benchmark)
2.6%
5.7
11.3%
2.2%
0.1%
2.2%
2.5%
3.3%
US Corporate Investment Grade Bonds
3.7%
7.0
14.1%
2.9%
0.8%
2.8%
2.7%
6.0%
US Treasury TIPS
2.3%
4.9
9.7%
2.0%
-0.1%
2.0%
2.3%
5.5%
Global Bond
1.8%
6.6
13.2%
1.1%
-1.0%
1.4%
2.0%
5.7%
US Corporate High Yield
9.0%
4.4
8.7%
8.9%
6.6%
5.8%
6.5%
12.2%
Emerging Market Bond
6.4%
6.9
13.7%
5.8%
3.6%
4.2%
5.5%
7.8%
Expected Returns (Barclays US Treasury 7-10 Years) (Barclays Municipal Bonds)
(Barclays US Corporate IG Bonds Index) (Barclays US Treasury TIPS)
(Barclays Global Aggregate Bond Index) (Barclays US Aggregate High Yield) (JP Morgan EMBI Global Diversified Index)
Market Risk Building Block Starting Div. Yield
Div. Growth
Valuation Change
Nominal
Real
2015 CMF
2014 CMF
Risk
US Large Cap
2.8%
4.2%
-2.5%
4.5%
2.4%
3.5%
5.7%
16.9%
US Small Cap
2.2%
4.2%
-2.1%
4.4%
2.3%
-0.4%
5.4%
20.8%
Starting Div. Yield
Div. Growth
Valuation Change
Nominal
Real
2015 CMF
2014 CMF
Risk
Int’l Developed Markets
2.4%
3.0%
2.1%
7.6%
5.5%
7.4%
8.0%
20.1%
Small Cap
1.6%
2.2%
2.1%
6.0%
3.9%
8.4%
8.9%
22.8%
Europe Benchmark
3.7%
2.0%
1.6%
7.4%
5.3%
N/A
N/A
21.9%
Japan Benchmark
1.6%
4.1%
3.8%
9.8%
7.7%
N/A
N/A
16.7%
Emerging Markets
2.6%
7.8%
2.8%
13.7%
11.6%
8.2%
9.9%
24.9%
World Equity Benchmark
2.6%
3.9%
-0.3%
6.3%
4.2%
6.3%
6.5%
18.4%
Starting Div. Yield
Div. Growth
Valuation Change
Nominal
Real
2015 CMF
2014 CMF
Risk
REITs
3.6%
-2.2%
4.5%
5.9%
3.8%
3.2%
4.9%
25.8%
MLPs
8.7%
-2.1%
-1.1%
5.3%
3.2%
10.9%
8.5%
20.4%
Risk Premium
Annual Inflation
Nominal
Real
2015 CMF
2014 CMF
Risk
2.4%
2.1%
4.6%
2.5%
4.1%
4.3%
20.3%
Expected Returns (Russell 1000) (Russell 2000)
Expected Returns (MSCI EAFE)
(MSCI EAFE Small Cap) (MSCI Europe) (MSCI Japan)
(MSCI Emerging Markets) (MSCI ACWI)
Expected Returns (FTSE NAREIT Equity) (Alerian MLP Index)
Expected Returns Commodities
(DJ UBS Commodity Index)
Annualized Return
Annualized Return
Annualized Return
Annualized Return
CAPITAL MARKETS FORECAST 2016
35
APPENDIX PRISM INPUTS (cont.) Manager Skill Building Block Annualized Return Expected Returns
Nominal
Real
2015 CMF
2014 CMF
Risk
Manager Skill
5.0%
2.9%
5.0%
8.0%
7.0%
Manager Skill Benchmark
3.5%
1.4%
3.5%
4.9%
4.9%
(Hedge Funds)
THE ART & SCIENCE OF INVESTING
(HFRI FOF Index)
36
Private Capital Building Block Annualized Return
ACWI
Return Premium
Nominal
Real
2015 CMF
2014 CMF
Risk
Private Capital
6.3%
3.0%
9.3%
7.2%
11.8%
11.8%
24.0%
Private Equity
6.3%
5.0%
11.3%
9.2%
10.8%
10.8%
9.5%
Expected Returns (Private Equity, Nat. Resources) (Cambridge Private Equity Index)
CAPITAL MARKETS
FORECAST 2016
LEGAL General This information has been prepared by Balentine LLC (“Balentine”) and is intended for informational purposes only. This information should not be construed as investment, legal, and/ or tax advice. Additionally, this content is not intended as an offer to sell, or a solicitation of any investment product or service. Outlook Opinions expressed are solely the opinion of Balentine and should not be relied upon for investment decisions. Certain statements contained herein may constitute projections, forecast, and other forward-looking statements that do not reflect actual results, and are based primarily upon applying retroactively a hypothetical set of assumptions to certain historical financial information. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. These statements are based on available information and Balentine’s view as of the time of these statements, are subject to change, and are not intended as a forecast or guarantee of future results. Actual results, performance, or events may differ materially from those expressed or implied in such statements. Third-Party Data The information presented in this publication has been obtained with the greatest of care from sources believed to be reliable. However, stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. Some material may contain information and data provided by independent, third party sources. While Balentine uses sources it considers to be reliable, no guarantee is made regarding the accuracy of information or data provided by third-party sources. Balentine expressly disclaims any liability, including incidental or consequential damages, arising from errors or omissions in this publication. Risk Investing in securities involves risks, including the potential loss of principal. While equity securities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results. The appropriateness of an investment or strategy will depend on an investor’s circumstances and objectives. These opinions may not fit to your financial status, risk, and return preferences. Investment recommendations may change, and readers are urged to check with their investment advisors before making any investment decisions.
CAPITAL MARKETS FORECAST 2016
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THE ART & SCIENCE OF INVESTING
LEGAL
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Terminology Balentine utilizes a building blocks approach to asset management. Our five building blocks include Liquid, Safe, Market Risk, Manager Skill and Private Capital. While each building block plays a role in diversification and risk management, all building blocks are subject to their own risks and may lose value. Specifically, the assets in the Safe building block are designed to protect against interest rate fluctuations, credit risks and unanticipated movements in inflation and currency valuations. Safe assets play an important role as a short-term shock absorber, but there is no inference these assets cannot lose value. More information on our building blocks strategy can be found on our website. Balentine Strategies Performance Data Performance information for Balentine Strategies (“Strategies”) is computed using weighted average performance of portfolio components (which may include public indices and/or specific investments managed by third-party providers) based on the recommended target weighting for each Strategy during the specified time period. Given that investors cannot invest directly in the indices, Balentine selects passive index funds as proxies for the underlying indices to manage the Strategies. These index funds may be changed from time to time in Balentine’s judgment to best reflect the performance of the indices. Performance is presented net of (after deducting) the actual embedded expenses of the active or passive funds or vehicles in which investments were assumed to be made (2000-2009) or actually made (2010-Forward), but before deducting a) Balentine’s investment advisory fees which will vary depending on each client’s circumstances and b) transaction costs of implementation (between .15% and .20% per annum). Balentine’s investment advisory fees are described in Part 2 of Balentine’s Form ADV. As an example of the compounding effect on advisory fees, a Balentine client paying an annual advisory fee of .90% (deducted monthly in arrears) would have experienced an average annual reduction of .904% from the performance data displayed. The results of the Strategies reflect the reinvestment of dividends and other earnings. Performance information presented for the Strategies for 2000-2009 represents back-tested information for the periods indicated, using monthly rebalancing. Back-testing of performance is prepared using Balentine proprietary asset allocation models that start with the first day of the given time period and evaluate the weighted average performance of the stated indices based on the recommended target weighting for each Strategy. The presentation of Public Markets (PM) strategies represents the fully diversified strategies excluding the allocation to hedge funds where the allocation to hedge funds is proportionally allocated to remaining asset classes. This performance information reflects asset allocation recommendations made to clients but assuming use of index funds only to implement. Accordingly, this information does not represent actual account performance and should not be interpreted as an indication of such performance. Investment decisions during this period were made by members of Balentine’s Investment Strategy Team while employed by Wilmington Trust Company through 2009.
CAPITAL MARKETS
FORECAST 2016
Conversely, all Balentine performance information presented beginning January 1, 2010 represents actual model performance rebalancing decisions in the investments for each Strategy as and when decided by Balentine’s Investment Strategy Team. Each Strategy is invested in the active or passive investment vehicles selected by the Investment Strategy Team and then implemented across all client portfolios. Individual client results may differ by reason of investment in underlying vehicles different than those assumed for the strategy. As with any investment strategy, there is potential for profit as well as possibility of loss. Past performance is not a guarantee of future results.
CAPITAL MARKETS FORECAST 2016
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THE ART & SCIENCE OF INVESTING
Copyright Notice Copyright ©2016 Balentine LLC. All rights reserved. No part of this publication may be reproduced or used in any form or by any means — graphic, electronic, or mechanical, including photocopying, recording, taping, or information storage and retrieval systems — without written permission from Balentine. To obtain permission, please write to the address below or contact us through electronic mail at info@balentine.com. Please specify the data or other information you wish to use and the manner in which it will be used, and attach a copy of any charts, tables, or figures derived from the information. The information presented in this publication has been obtained with the greatest of care from sources believed to be reliable. However, Balentine does not guarantee the accuracy of information provided by third-party sources. Balentine expressly disclaims any liability, including incidental or consequential damages, arising from errors or omissions in this publication. Third-party data sources include FactSet, Standard & Poor’s, Preqin, National Council of Real Estate Investment Fiduciaries, Robert Shiller, Morningstar, Ibbotson Associates, Ned Davis Research, Hedge Fund Research (HRI) and Cambridge Associates. Published by: Balentine 3344 Peachtree Road Suite 2200 Atlanta, Georgia 30326 Telephone: 404.537.4800 Online: www.balentine.com
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