Investors should avoid embracing more risk to chase returns, despite buoyant equity markets defying recent global shocks, warns American institutional investment consultant Wurts and Associates.
Further adding to its risk avoidance outlook, Wurts said inflationary pressures means rates were likely to rise next quarter and the best way to protect portfolios was to reduce equity allocation.
“The intuitive and most commonly heard answer is to go short duration on fixed income to avoid duration-based losses as rates go higher. It turns out this is not the best idea because of lost fixed returns, given the steepness of the yield curve. Instead if you’re looking to make a shift in asset allocation, reducing the equity allocation gives more bang for the buck, at least assuming risk premiums remain intact.”
This strategy is further strengthened by Wurts’ pessimistic outlook for US GDP growth.
Disagreeing with those who think there is still good value in equities, Wurts said investors should look beyond trailing and forward 12-month PE ratios indicating prospective returns of 8-9 per cent.
Taking a a longer term view reveals US corporate profits as a percentage of GDP are nearly 20 per cent above their historical average.
Adding to their pessimistic outlook for equity returns, longer-term metrics such as the Shiller PE and Tobin’s Q ratios both indicate equities were priced to provide around a 6 per cent rate of return over the next decade.
While taking on more equity risk could be seen as a potential panacea for generally accepted laggard returns in fixed-income investments, Wurts said equities would not escape what it described as the “low returns environment for the next decade”.
“What’s interesting for us to see from the investment community is how most would agree this (low returns) is true for fixed income, but somehow believe it’s not the case for equities. The implicit rationale of course is fixed income and equity markets are somehow unrelated to one another over time, or that risk premiums are inconsequential considerations. We’re not trying to be preachy or pretend to be all knowing, but do need to be realistic and emphatically state this just isn’t the case.”