Introduction to the 3Q 2021 Quarterly Letter
By Ben Inker
This quarterly is a piece written by my Asset Allocation co-head John Thorndike. In it, he explains the rationale behind our strong preference for non-U.S. stocks despite the stellar performance the U.S. stock market has delivered over the last decade. The research behind the piece is an example of the bread and butter of our historical asset allocation analysis. In this short companion piece I wanted to explain a bit why we are so enamored of this type of analysis, which examines not just historical returns, but the underlying components of those returns.
Historical analysis of markets is crucial for trying to understand future potential returns. The trouble is that a standard way of doing this type of analysis – calculating average returns for an asset over time – can be extremely misleading. It is tempting to assume that over a long enough period of time historical returns are representative of what returns can be expected going forward, but that may not be the case. We believe It is only by taking the further step of delving into the components of that return that it is possible to come up with a reasonable estimate of what returns might be expected going forward. This is probably easiest to see in bonds, so in this piece I will show how a historical view of bond returns can give a grossly misleading impression of what investors might expect going forward. Exhibit 1 shows the rolling 10-year returns to the U.S. 10-Year Treasury Note.
The average decade gave you a return of around 7.6% with a standard deviation of 2.9%. The last decade has seen just about the lowest return over the period, at 3.4%, and judging only from this exhibit one might be tempted to say the odds are the next decade will be better – after all, 99% of all the historical 10-year periods in the last 60 years gave a higher return. Is a 7.6% return a fair expectation for future returns from 10-Year Treasuries? Would 3.4% be a conservative forecast? By analyzing the sources of returns we can get a better idea of why the first forecast would be absurd and even the second is almost certainly unrealistically optimistic. Exhibit 2 shows the drivers of return for 10-Year Treasuries since 1961.
Yield change has been a positive piece of returns over this period, but it would be unwise to assume this will continue to be the case simply because it has been true on average historically. The rather large elephant in the room here is the yield component, which has averaged 6.0% over the last 60 years, whereas a 10-Year Treasury Note today yields less than 1.6%. A simple forecast methodology inspired by this component of return breakdown would be the current yield plus average roll-down, or 2%.1 As Exhibit 3 shows, this simple forecast methodology would have explained 71% of the historical variation of bond returns over the subsequent decade, and today’s forecast is lower than any realized 10-year return in this dataset.
It’s worth pointing out that this lowest-ever forecast for bonds does not require any assumption of mean reversion in valuations. It is no secret we tend to build in an assumption of mean reversion in the medium term to our asset class forecasts. History suggests that valuations are generally mean-reverting over time, but valuations are a crucial driver of future expected returns for assets even if valuations do not mean revert. Investors would be wise to keep that in mind because bonds are by no means the only asset today where valuations are far higher than their history, from which, of course, most long-term return assumptions are drawn.
I will admit that the same fact that makes the bond example so instructive also makes the components of the return result less surprising. Bond math is inexorable enough that the current bond yield tells us most of what we need to know, and few investors base their bond forecasts on the simple historical return analysis that I’m suggesting would be so misleading. But investors do often use just this type of analysis both in the case of more complex asset classes such as equities or commodities and for multi-asset strategies such as 60/40 or risk parity. When applied in those cases, this analysis has, of course, the same flaws.2 Analyzing the components of return and estimating them going forward is certainly more complex than simply looking uncritically at historical returns. But as John’s piece will show, it is every bit as important to analyze the drivers in those more complicated cases instead of assuming the raw returns are telling us what we need to know.
WINNERS, LOSERS, AND THE CASE FOR OWNING EACH
by John Thorndike
Executive Summary
We reiterate our preference for non-U.S. equity markets based on an analysis that shows that U.S. fundamental performance has been ordinary in the context of history and insufficient to justify the market’s extraordinary valuation return.
- Equity market performance can be decomposed into changes in valuations and a “fundamental return” that comprises growth and reinvestment of income.
- U.S. equity market performance led the world for the 10 years ending September 30, 2021, which has left the U.S. market trading at a significant valuation premium relative to non-U.S. stocks.
- Many investors believe that the U.S.’s greater fundamental performance justifies the market’s much higher valuations. Over the past 10 years, U.S. companies delivered fundamental performance 45% higher than the rest of the world, impressive indeed. Over the same period, the U.S. stock market valuation multiples rose more than 85% faster than the rest of the world – far outpacing their fundamental upside.
- Japanese companies delivered better fundamental performance than U.S. companies over the last decade, yet Japan trades at two-thirds of the valuation multiple of the U.S. market.
- Fundamental performance in European and Emerging Markets was disappointing; however, history suggests that fundamental performance tends to revert to trend, so we can reasonably expect better fundamental returns over the next decade.
- In our view, the much lower starting valuations of non-U.S. markets will provide a tailwind for future returns.
- We continue to believe equity investors will be rewarded for allocating as much of their equity exposure to non-U.S. markets as their risk tolerance allows.
Introduction
GMO’s Asset Allocation portfolios express three strongly held views: 1) value stocks globally are cheap relative to growth; 2) non-U.S. equity markets are cheap relative to the U.S.; and 3) traditional fixed income yielding less than inflation offers little benefit to portfolios. Recently, we’ve written extensively about the relative value opportunity for owning value stocks.1 This quarter, we turn to our preference for owning stocks in non-U.S. markets. We look at the winners and losers of the last 10 years by analyzing both the returns of equity markets and the fundamentals of the companies that comprise them. No one reading this quarterly will be surprised to see the U.S. equity market as the leading performer over the last decade, but some may be surprised to learn that Japanese companies delivered the best fundamental performance over that same period. We wrap up by considering the potential for last decade’s laggards to produce a better showing in the decade to come. Readers will see that non-U.S. markets are home to both winners and losers from the last 10 years while offering starting valuations that should position these markets to outperform the U.S. in the decade to come.
U.S. Exceptionalism has been Driven by Multiple Expansion
No review of equity market performance over the last decade can start without acknowledging just how strong performance has been for U.S. stocks. During the 10-year period from September 2011 to September 2021, the MSCI U.S. index grew at a 16% annualized pace, generating gains of nearly three and a half times capital. Over the same period, non-U.S. stocks, as measured by the MSCI All Country World ex-U.S. index, grew at less than half that pace (an otherwise respectable 7.5% annualized return) and delivered less than one-third of the gains of the U.S. market (see Exhibit 1).
Continue reading with charts here.
