From both an equities and fixed-income perspective, portfolios are expected to stay ‘in a lower-return orbit’
Investors had best keep their portfolio return expectations on the low side, based on Vanguard Canada’s outlook for global capital markets.
“The market’s efficient frontier of expected returns for a unit of portfolio risk is still in a lower-return orbit,” Vanguard analysts said in the firm’s economic and market outlook for 2019. “More important, common asset-return-centric portfolio tilts, seeking higher return or yield, are unlikely to escape the strong gravity of low-return forces in play.”
On the equities side, the firm noted that the Canadian market has trailed other regions in the years since the global financial crisis, leading to lower valuation levels for Canadian equities. Referring to its proprietary method of determining equity valuations, which accounts for current interest rates and inflation levels, Vanguard said that Canadian equities are sitting within the lower end of past valuation levels.
“[O]ur expected return outlook for Canadian equities over the next decade is centred in the 2.5%–4.5% range, in stark contrast with the 8.8% annualized return generated over the last 30 years,” Vanguard said. It expected the valuation expansion that has lifted returns during the past three decades to subside in the face of gradually rising interest rates, and noted that the expected risk premium of Canadian equities over cash appears compressed.
“From a Canadian-dollar investor’s perspective, the expected return outlook for non-Canadian equity markets is in the 4%–6% range,” the report said, adding that the corresponding equity risk premium is expected to contract less than the risk premium for Canadian equities. “[O]ur ten-year outlook for global equities (in Canadian dollars, unhedged) is in the 3.5%–5.5% range … Although the case for global diversification is particularly strong now, for the purposes of asset allocation we caution investors against implementing tactical tilts based on just the median expected return.”
Looking at fixed income, Vanguard Canada saw an improved outlook as a result of higher interest rates. A recent expansion in credit spreads has contributed to a greater differentiation of expected returns from riskier income sub-asset classes when compared with previous years.
The firm forecast a modest risk of a material rise in long-term interest rates in Canada despite the increase in short-term policy rates. The firm expects the short end of the curve to rise faster than the long end, where rates are anchored by inflation expectations, over the next decade. For this reason, it considered duration strategies to be “fairly valued and less risky than investors may believe in a rising rate environment.”
Investor caution was urged in credit or emerging-market segments of corporate fixed-income, where relatively high valuations may offset the expected yields. But from a geographical perspective, the firm maintained that the diversification benefits of global fixed income will persist under most scenarios even if the expected return for ex-Canada aggregate bonds were marginally lower than that of Canada aggregate bonds.
“Ultimately, our global market outlook suggests a somewhat more challenging environment ahead, yet one in which investors with an appropriate level of discipline, diversification, and patience are likely to be rewarded over the long term,” the firm said.