Equilibrium Capital Market Expectations (CME) are a vector of expected returns (cash rate plus risk premiums) and a matrix of covariance for the asset classes in which we either invest or may invest client assets. They are used to compute strategic asset allocations and long-term simulations. In addition, the risk premiums included in the expected returns are used as discount factors in our valuation models. These expectations are the projection of average asset class behavior over the next 30-40 years or longer. We use the term Equilibrium because we assume that economic and financial variables ultimately regress to an internally consistent regime around a long-term steady state.
These Equilibrium expectations are useful in indicating a “ballpark” benchmark for the portfolio, helping portfolio manager and client express in a common language what the suitable risk and return characteristics would be for a portfolio over very long time periods. However, when establishing a strategic asset allocation, we find it more useful to utilize Baseline expectations, which include more information about the current market conditions.
We believe that the intrinsic value of an investment is determined by the fundamentals that drive its future cash flow. This is true for all investments in the capital market be they stocks, bonds or alternative assets. Our estimate of intrinsic value is forward-looking and discounts back to the present the future cash flows available to current and successor shareholders. It does not use shortcut ratios such as price/earnings, price/ book value, price/sales or dividend/price (yield) as proxies for intrinsic value.
Asset prices tend to fluctuate around intrinsic value.
Discrepancies between market price and intrinsic value arise from market behavior and market structure, providing opportunities to outperform. Common behavioral biases of market participants include over-reaction to short term noise and under-reaction to structural change. Our price/intrinsic value approach supports our ability to maintain discipline in the face of short-term noise and is forward-looking so as to incorporate structural change and key trends.
ValMod (Valuation Model) is a tool developed by Investment Solutions (IS) within UBS Asset Management, and used for the fair valuation of various asset classes within local and global markets. The model comprises a discounted cash flow (DCF) analysis which means a theoretical price for the considered asset, such as equity or bond, is derived.
The DCF technique is based on the estimation of the two main financial attributes of an asset: (i) all future cash flows to the investor stemming from the given asset need to be forecast, and (ii) proper assumptions on the applicable discount rates have to be made in order to bring the derived cash flows back in time via present value calculation. Finally, the summation of all those discounted cash flows results in the model-based fair value of the underlying asset.
Through comparing the corresponding current market price to the fair value obtained from the model, portfolio managers are able to draw conclusions on how to position themselves and decide whether to overweight or underweight their exposures to certain asset classes or markets. Using these valuation metrics we formulate our intermediate-term expectations for a range of asset classes.
Integrating demand side and supply side estimates
There are two general approaches to setting capital market assumptions: the supply side and the demand side. When done properly, these two approaches tie in together and are consistent with each other.
Demand and supply side components: Equilibrium US equity returns
The function of tactical (short-term) expectations
Valuation measures, such as Professor Shiller’s Cyclically Adjusted P/E Ratio or our proprietary valuation model ValMod (which covers both equities and fixed income in a consistent framework) provide useful information about market returns over the medium term.
Strategic asset allocation
One of the most important decisions investors make is to determine their asset allocation. This sets the portfolio composition in terms of asset classes, such as US stocks, European stocks, US bonds, etc., for reasons of achieving the best risk-return ratio for the investor’s needs. The strategic asset allocation (SAA) represents the average or so-called “normal” allocation.
The characteristics of asset classes can be very dependent on the time period chosen. It is not hard to find 10-year time periods for which equities have underperformed fixed income and there are even 20-year periods for which equities have underperformed segments of the fixed income market. For example, the 20 years up to June 2019 shows equities underperforming.
Over the long run, there is a strong relationship across asset classes:
- Cash has the lowest return and risk. Generally, the risk is in the 0.5% to 1.5% range. One issue is that the more granular the data, the greater the serial correlation.
- Broad investment grade fixed income has volatility in the 4.0% to 5.0% range, but is has been quite low in the last couple of decades. Long fixed income has volatility in the high single digits to the low double digits (8.0% to 12.0%).
- Non-investment grade fixed income shows volatility in the 10.0% range, but this can vary quite dramatically, being very stable in growth periods, but spike in volatility suddenly.
- Unlevered real estate generally falls in risk in the mid to low single-digit range when looking at quarterly data. However, as discussed in the alternatives section, the high serial correlation masks some of the actual annual volatility. Using some different measures, we get unlevered real estate to be around 9.0%-10.0%.
- Equities have volatilities that range as low as 12.5% for diversified portfolios to the 25.00% range for emerging markets countries. Generally, broadly diversified equities have volatility set around 14.5% to 16.0%.
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