Asset Class Returns – SAA: Executive Summary

What asset class returns are likely going forward?

In a recent investor meeting, Copenhagen Allocation Partner presented its assumptions about returns over the coming 5 years and how they fit into our Strategic Asset Allocation optimization.

We also outlined our approach to Dynamic Asset Allocation and how this overlay can complement the strategic level to enhance performance.

Return Assumptions

  • Developed market equity returns will be lower than their recent historical record. The key factor reducing returns will be further narrowing of profit margins in this late part of the cycle.
  • Medium returns on long-dated government bonds will likely be negative. Our models suggest that this cost is still outweighed by their capacity to hedge macro risks.
  • High Quality credit will continue to outperform government bonds moderately.
  • The default rate on Low Quality credit will increase which will widen the credit spread. This will reduce returns, but not excessively.
  • Credit spreads on Hard Currency EM debt will follow DM government debt closer than DM High-Yield. The asset class will continue to deliver a notable yield pick-up.
  • EM equities will converge on long-term profit growth of 6% after the profit recession in 2019. This will improve returns going forward.

Cross-Asset Macro Themes

  • Secular factors remain in place among the Big Four (US, Eurozone, Japan, and China). Low growth in the labor force and muted growth in productivity will continue to limit growth in potential GDP going forward.
  • This is made more important by the late-cycle position of the advanced economies and limited slack. The US is a particular case in point.
  • In the case of China, growth will continue to moderate softly, held back by a combination of structural issues, the transition to a domestic demand-driven model, and reduced leeway in both fiscal and monetary policy.
  • Inflation will remain muted in the advanced economies, although we look for a slight uptick in US inflation. Most of the upward pressure on labor costs will translate into a narrowing of profit margins.
  • Against this backdrop, we expect monetary policy to remain lax throughout. The end-of-period scenario will see the Fed Funds rate normalized around its current level, but we factor in a likely return to zero rates before the end of the 5-year period.
  • In the case of the ECB, a zero percent repo-rate is expected to prevail for another 2 years, followed by a normalization to a level around 0.5%. The controversial negative deposit rate will likely be abolished before this.

Optimizing the SAA

Our optimization procedure combines two different approaches to emulate different risk-return preferences. Emphasis is placed on obtaining the maximum diversification effect in crisis scenarios or ”bad times”. The optimization procedure informs our SAA as follows:

We highlight the following:

  • High-Quality fixed income assets receive a significant weighting despite negative return expectations. Our actual SAA is tweaked slightly lower to reduce the negative return drag.
  • Low-Quality fixed income assets (both DM and EMs) and US equity receive a higher than model weight as a consequence.
  • European equities maintain a significant SAA weighting, close to the model output.

Dynamic Overlay

  • Our SAA process is only the first step in a three-step process to build our tradable model portfolio named CAP-M.
  • In the second and third step we collect macro and market data and transform this data into tradable signals DREX – or Dynamic return Expectations.
  • In our second step we perform an optimization process for assets within each of our sub portfolios: Low-Risk, High-Risk, Risk-off, & Risk-on. In a back-test from 1997-2019 we are able to add 70 bps to our SAA portfolio performance.
  • In our third step we perform another optimization process between each of our sub-portfolios: Low-Risk, High-Risk, Risk-off, Risk-on & CAP Bear. In a back-test from 1997-2019 this step in our portfolio optimization process adds extra 165 bps to our SAA portfolio performance.
  • The three-step investment process enables us to: I) Harvest a DAA-premium,II) Reduce portfolio risk considerably.