Projecting Long-Term Returns

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Text transcript

Eric Morin, senior analyst, CIBC Asset Management.

In a world of low growth and low interest rates, it’s more difficult to find opportunities [for] return than usual. In January, we published our annual long-term expected returns publication. At the time, most asset classes for risky assets were overvalued and only a few were undervalued. Now, it’s a totally different story because most asset classes are now undervalued compared to long-term fundamentals. When markets are correcting and uncertainty is elevated, it’s important to be mindful that price corrections sow the seeds of investment opportunities.

To identify opportunities, we rely on two complementary inputs. The first one is we rank asset classes for their attractiveness. This is important when you have a lot of asset classes across countries to cover. For example, we cover asset classes for equity fixed income and currencies for more than 30 economies. Our key pillar for attractiveness, or one of our key pillar for attractiveness, is evaluation. More precisely, we compare current market prices with their respective long-term fair value. We rank the deviation across countries in order to identify undervalued and overvalued assets.

For each asset classes that we cover, we have a long-term fair value estimate that change a little from one year to another. We can really look at relative overvaluation or undervaluation from a really long run perspective — so we can look beyond the cycle. The long-term for value estimate, we derive them from our long-term expected return projection. We have projections for demographics, productivity, long-term debt, policy rate, etc.

Once we have a ranking for attractiveness, and in a second step, we conduct country-specific macro research. When we invest, adding a good signal from a model or from the model is not sufficient, the other tool that we have is we look at countries through the lens of qualitative research as an economist. For example, our research could indicate that a country with a good ranking, so that shows some undervaluation, it could look good from a ranking perspective. However, it could have important external funding vulnerabilities which could reduce our appetite for this asset class. We really look at… We have two tools. First, we rank asset classes and we identify prospect to buy or to sell. Then, we conduct qualitative research on those countries in a subsequent step.

Trendy asset classes are undervalued, as I said compared to long-term fundamentals, so it’s important to look at the good cyclical factor at the good moment because financial markets are… They generally move quickly with anticipation regarding the cycle. For example, in 2009, risky assets started moving up before the official end of the Great Recession, which was in June 2009, so timing is important as well.

There are three things that are important to look at over the next few months. The first one is the epicenter of the crisis, which is the Covid-19, so it’s going to be important to look to see if we have increasing signs of stabilization of the outbreak on one hand. On the other, it will be important to look at the pace at which the virus will be spreading in a world where lockdown will be eased and where social distancing will prevail. Development regarding the virus are important.

The second factor is the policy response. More precisely, we will have to look at the stance from government and central banker. We want to see if they will continue to pledge that they will deliver whatever it takes for the economy. This is really important because with this statement, it favours a lower risk premium for risky asset, which is an important win for undervalued risky asset. This, again, most important thing is the commitment from policy maker regarding their appetite to deliver whatever it takes.

The last important area is finding early economic confirmation of expectations. By that, I just mean that we have to look at key cyclical and forward-looking indicators, such as the PMI indexes or new orders. This is important because you need a green light from those indicator before taking more risk onboard.