Risk Wire 2016-1: Outdated Expectations in a Changing World

Advances in automation accelerate the trend started by the globalization – higher total factor productivity and GDP growth combined with low incomes and unemployment. As it turns out, our return expectations are not aligned with these realities of today.
Return assumptions for the largest and most liquid asset classes are the key inputs in any asset allocation exercise and consequently pretty much determine the outcomes. The fact that these assumptions are critical and should be carefully examined is now fully acknowledged. It is also understood that these assumptions should be consistent. But consistent with what? The usually taken path is to build expectations consistent with actual history: average historical P/Es and mean reversal assumptions, for instance, can be a basis for calculating expected equity returns. Average yields over the last ten years could help build expectations about the yield levels in the future.
Historical consistency, however, comes at a price. What if historically consistent returns are inconsistent with today’s facts? This is very much the situation we find ourselves today. There have been expectations of rising yields for years now – expectations that have to date caused downfall of illustrious careers. However, yields have remained stubbornly low, even continued to decline. Margins and returns on capital in the U.S. are uncharacteristically and stubbornly high, but so is the unemployment rate (by historic standards at any rate). Making sense out of all this requires consistency not with history, but with today’s realities: the world has changed (as it always does) and expectations should change with it.
One such expectation is higher interest rates – the ever unsuccessful attempt to find that elusive “normal” level of rates. We demonstrate how (and why) yields may continue to fall and sustain even negative levels for a considerably long period of time. Our point of departure is the Graham Risk framework – the cross-asset valuation and risk framework used by LINKS (a complete description and a sample interactive spreadsheet available here).