10 Year Forecast & Why it Matters
Luc de la Durantaye
Managing Director, Asset Allocation and Currency Management,
CIBC Asset Management
“Contrary to popular belief, it’s actually easier – not that forecasting is easy at any time – but it is easier to forecast 10 years out than forecasting one year out. And the reason for that is that the drivers of 10-year out returns are more stable and less volatile than the 1-year variables that we use to forecast 1-year returns. As an example, when we look at 10-year government bonds, whether you look at 10-year Canadian or U.S. government bonds, the starting yield to maturity of a government bond gives you a very good approximation of what the expected return 10 years out. That exercise demonstrates that it’s highly correlated so when you look at the yield to maturity starting point today, it’s correlated to up to 90 percent to your actual realized return 10 years forward.”
3 Main Drivers of long-term returns
“There are three main ones. One is the starting yield. So for a bond, it’s the coupon that the bond is providing. For stocks it is the dividend yield. All else equal, the higher the coupon or higher dividend yield, the higher the future expected return. The second driver is growth. So, growth is estimated via potential GDP of each country to determine what is the potential corporate earnings growth. So, over a long period of time, earnings growth or corporate profits are well tied to economic activity. We look at GDP growth potential to estimate corporate earnings growth over time. Obviously the higher the potential GDP the higher the future expected returns. And finally, valuation, the starting valuation is very important. Valuation is for a particular equity market, we use price earnings, and cyclically adjusted price earnings, and all else equal again the lower the valuation the higher the future expected returns.
How are we currently positioned?
Well, on the first variable, the starting yield in bonds, and as well to a certain degree to equity, by a historical standard, is lower. So that component is starting from a relatively low base. The second point being the growth, We know that demographic is going to be a bit of a challenge, a bit of a headwind, because of the aging population. We know that the starting point in terms of debt is relatively higher. So a normalization of monetary policy will also be a headwind because of the high debt levels. So in terms of growth we have a little bit below average historical growth going forward. The third element is the valuation, and here we have different readings. If you look at the U.S. equity market, U.S. equity market’s valuation is relatively high by historical standards. International markets are fairly valued, so the expected return from valuation is decent for international equities. It is most attractive for emerging markets, which are trading at a fairly large discount relative to the U.S. market.
What does this mean for investors?
Generally speaking I think it’s important that an investor tackle the market in an active manner, both in terms of active stock selection, as well as active asset allocation selection, given the environment that we are walking into where there will be opportunities to expand return if one looks in the right area, and that exercise is made exactly to help the investor to find where the opportunities are.”