2020 Strategic Review: All Asset Classes More Expensive. Equities Remain Most Attractive

Executive Summary:

• DEVELOPED INTERNATIONAL: Developed international equities have spent most of the last decade well below the Price Matters® trendline with only occasional periods of reverting towards trend. Recognizing this, we have decided to take into consideration both a ‘optimistic-case’ and ‘conservative case’ scenario that recognizes both the potential for 1) the 1970-2020 trendline to persist and 2) the possibility that ‘this time might be different’ and the trend going forward may be permanently lower.The historical, faster trend line has become our ‘optimistic case’ scenario and is dependent on significant currency appreciation and significant structural reform. Our ‘conservative case’ scenario assumes that a new, lower trend is appropriate in the absence of structural reform and rising currencies.
  • For 2020, we have chosen as our base case scenario an assumption that splits the difference between the ‘best case’ trend of 6.4% and a ‘conservative case’ of 4.6%. We note that under either scenario, developed international is below trend both in absolute terms and relative to the US.
  • However, the distance from trend is less extreme in our ‘base case’ scenario than with the more optimistic trend-line that we have used in the past. This resulted in lowered expected returns and, therefore, lower model allocations to the developed international asset class for 2020, bringing them in-line with where our portfolios have been throughout 2019.
• US: US stocks remain above trend but continue to represent a larger allocation than overseas equities within our portfolios for the reasons described above. Additionally, we believe the above-trend readings are justifiable given the significant structural and fundamental advantages US companies currently enjoy over their foreign peers.
• EMERGING MARKETS: After being victimized in 2019 by trade war negotiations between the US and China, emerging market (EM) equities remain below their long-term trend and are the cheapest asset class in our asset allocation. Allocations to EM increased in each of our longer time-horizon portfolios.
• FIXED INCOME: Fixed income allocations increased this year relative to 2019 allocations despite prices increasing and yields falling year over year. The distinguishing difference for 2020 is that the updated model has built-in some inflation protection (TIPs) and shorter duration (high yield) than we had in 2019. We arrive at this allocation by assuming a steeper yield curve and higher inflation compared to current market expectations.

Re-Examining Eafe’s Trend

Since the inception of RiverFront in 2008, our strategic allocations and often our portfolios have contained a healthy allocation to international equities; both developed and emerging. Over the last 12 years, we modeled each asset class using our proprietary Price Matters® framework for drawing the long-term trend and then calculating each asset class’ distance from trend by evaluating price movements over time. During this period, developed international as represented by the MSCI EAFE (Europe, Australasia, and the Far East) Index has remained considerably below the calculated trend of 6.4%; at times nearing 45% below trend.

EAFE has shown few signs of mean reversion since the Great Financial Crisis (GFC); unlike US large caps and emerging markets equities. However, it is not unprecedented to have an asset class remain below trend for an extended period. US large caps, for example, experienced an 8-year period below its trendline with no signs of mean reversion from 1974 to 1982. While not unprecedented, it is unusual and therefore begs the question: ‘Is this time different?’ The Plaza Accord and the Japanese stock market bubble had an outsized impact that might call the 6.4% trend-line into question and thus lessen the potential magnitude of future mean reversion. Additionally, we wanted to understand what would need to happen to re-validate the 6.4% trend-line.

Recognizing the Impact of the Plaza Accord on Foreign Currencies and Japan

For a little background, the 1985 Plaza Accord was an agreement amongst the G5 (France, Germany, Japan, UK and the US) to allow the US dollar to depreciate relative to developed international currencies in order to correct trade imbalances with the US. Subsequently, the US dollar index fell nearly 50% over the following five years.

While the agreement did not fix the trade imbalance with Japan, the currency intervention did deliver its intended positive consequences on the European economy and stock market. Europe had been below trend until the Plaza Accord and then post-accord reverted to the trend for the next 10 years. Therefore, in order for our ‘best case’ scenario trend-line (6.4%) to be achieved, one of the necessary ingredients is that currencies, particularly the euro and yen, need to appreciate significantly.

While it is unlikely that we will experience another collaborative currency intervention like the one agreed to at the Plaza Hotel, significant currency appreciation is not impossible over the coming years. In 2011, both the Euro and the Yen were approximately 35% and 30% higher, respectively. We believe the key to currency appreciation is structural reform. This is why we added the fourth ‘R’ (Reform) to RiverFront’s 3 ‘R’s’ framework in our 2020 Outlook. Effective reform, in our mind, would involve easing of labor rigidity, lower tax regimes and easier business formation in Europe, as well as improved corporate governance and a more open labor market in Japan. While Japan has made meaningful strides in governance, both still lag behind in their labor reform efforts. Given the difficulty of achieving meaningful structural reform, our base case for 2020 uses the lower trendline.

The second and related event that had an outsized impact on developed international equities occurred in Japan between 1986 and 1991. Yen appreciation following the Plaza Accord and the Bank of Japan’s attempt to offset it by drastically lowering interest rates kicked off an asset bubble that peaked in 1989, imploding in spectacular fashion over the next couple of decades. A May 23, 2017 article by Brian Richards, a writer for the Motley Fool, helps put Japan’s dominance in the late 1980’s into perspective. According to Richards, in early 1989 eight of the world’s largest corporations were headquartered in Japan and Japan accounted for 45% of the world’s market cap, well ahead of the US, which was in second place at 33%. Today, Japan is less than 7% of the MSCI-All-Country world index and the US is over 57%. Japan does not have to experience another 1989-like asset bubble to re-validate the 6.4% ‘optimistic case’ scenario trend line, in our view. However, it does need to reverse the economic stagnation brought on by deflation and poor demographics and return to meaningful economic growth.

Setting Capital Market Assumptions For 2020

The setting of capital market assumptions is driven by RiverFront’s proprietary Price Matters® framework. Throughout the year, RiverFront updates its Price Matters® estimates of expected returns and downside risks for a wide array of global asset classes. Price Matters® return estimates fall as prices rise and increase as prices fall, consistent with historical market behavior. Downside risks are similarly a function of price, as overvalued markets have historically suffered the largest declines.

The strong equity returns experienced in 2019 by domestic, developed international, and emerging market equities make each asset class less attractive on an absolute basis, but relative comparisons introduce some slight allocation shifts for 2020. As shown on the chart below, the equity asset classes that began 2019 above trend ended the year further above trend and those that began below trend moved closer to trend. We believe equity asset classes benefitted from access to cheap capital, stock buybacks, and attractive relative prospects when compared to low yielding fixed income alternatives. Fixed income asset classes had a positive year as well, as yields fell and prices rose. Credit sensitive products saw spreads tighten in both investment graded bonds and high yield bonds as access to capital was plentiful and interest rates were lowered by the Federal Reserve.

Based on the strong economic backdrop and the equity asset class’ distance from trends combined with fixed income starting yields, the RiverFront investment team’s capital market assumptions were as follows:

• Equities should do better than fixed income.
• Emerging markets remain a cheap asset class.
• Short-duration bonds are preferable to long-duration bonds given today’s low starting yields and relatively flat yield curves.

Riverfront’s 2020 Asset Allocation Strategy

RiverFront seeks to set asset allocation models that will maximize returns while meeting the risk constraints appropriate to each strategy’s investment horizon. For each strategy, such as Moderate Growth & Income or Global Allocation, there may be multiple asset combinations with different risk profiles that satisfy this objective. At least annually, our investment team selects the long-term risk profile for each strategy based on their assessment of the present risks in the market. In the table below, we present RiverFront’s 2020 Strategic Asset Allocations for each of our strategies.

The table below highlights the changes between the 2020 and the 2019 Strategic Asset Allocations:

• Equities:
  • International: Allocations were reduced due to our decision to use a more conservative trend-line in our ‘base case’ scenario in developed international, as expected returns were lowered. The reduced allocation aligns with how the portfolios are currently positioned.
  • Emerging Markets: There was a net increase to emerging markets in our longest time horizon portfolio. Given the volatility of the asset class’ returns, the allocation was only increased in the portfolios that had more time to endure potential drawdowns. We believe that emerging markets have the greatest growth potential of equity asset classes given its distance from trend and the fact that trade headwinds are starting to dissipate.
  • Domestic: Domestic equities had an outstanding year in 2019, thus one would expect lower allocations in 2020. However, across most portfolios domestic equities increased as the beneficiary of developed international reductions. The one exception is within Moderate Growth & Income where a portion of the large cap allocation was shifted to short-duration fixed income to enhance the portfolio yield. Within domestic equities the longer time horizon portfolios reduced exposure to small-caps in favor of large-caps.
• Fixed Income: Yields fell in 2019 from 2.68% to 1.91% on the ten-year Treasury. This significant drop in yields also caused credit spreads on investment grade corporates to tighten, driving up price returns. RiverFront believes that investors should only expect coupon income in 2020 and should not expect the price appreciation experienced in 2019. Given the unlikelihood of significantly lower rates, we have removed longer-duration, lower-yielding securities from the shorter time horizon portfolios.
  • Short-Term High Yield: This asset class offers approximately 300 basis points in additional yield, relative to Investment Grade Corporates, while shortening duration by almost 6 years as interest rates are expected to rise over the next 3-5 years. The incremental yield pickup is additive to returns across all time frames as long as the economy stays out of recession as we expect.
  • Treasury Inflation Protected Securities (TIPS): TIPS were also added to the allocations of Conservative Income Builder and Moderate Growth & Income to help mitigate inflation eroding the purchasing power of investments. We believe that current market inflation expectations, as represented by breakeven rates of 1.63% over the next five years are too low, and we modeled average inflation of 2.50% over the time horizon of the portfolios.
  • Treasuries: We added Treasuries in the shorter time horizon portfolios to act as potential shock absorbers to any market drawdowns. Our shorter portfolios have some simulation outcomes that are negative, so it is important to add an allocation to an asset class that is defensive and mitigates potential losses in a worse-case scenario. In the longer horizon portfolios, there were no negative outcomes at the horizon and therefore the use of Treasuries as shock absorbers is not needed