But even most US equity bears won’t go as far as to predict the asset class producing negative returns after inflation over the next 7 years. And yet, GMO does exactly that: the Boston-based asset manager sees US large caps producing annualised real returns of -4.4% (assuming annual inflation of 2.2%) over the period. Small caps are projected to do only marginally better with expected returns of -3%. This compares to a long-term average historical return of 6.5% per year.
Valuations: a lid on returns
GMO has decreased its already low long-term return forecast by about 1% for both asset classes from last year as the gains made by US equities over the past year have been mainly valuation-driven.
“Our forecasting framework is grounded in valuations,” explains Catherine LeGraw, a member of GMO’s asset allocation team. “We assess what future returns have already been priced in, and what the long-term expected return would be if we were to go back to fair valuation levels,” she adds.
GMO’s forecasts are based on the expectation that asset valuations will return to historical means. For the S&P 500, this is a P/E ratio of 16, which was last seen in early 2013.
LeGraw: “While we expect a positive return from growth and income for US stocks, we forecast a [deeply] negative returns from valuations as we expect them to normalise.”
Value in EM
One of few asset classes GMO is prepared to overweight is EM stocks, and (unsurprisingly, perhaps) especially those stocks with cheap valuations.
While GMO has cut its return forecast for EM assets by more than half after strong, valuation-driven returns this year, EM equities are still set to provide real returns of 2% annually, the asset manager believes.
And these returns are mainly to come from value stocks. “In our unconstrained Global Real Return Ucits (multi-asset) fund we have an allocation of 24% to EM value, which we have had since 2015 and have increased recently,” says LeGraw.
It’s questionable, however, if EM value stocks would really be your best bet, even if valuations look cheap. EM value stocks are highly geared to commodities, which are thought to permanently trade on lower multiples than even a few years ago for structural reasons (such as the decline in commodity prices).
EM value has also strongly underperformed the wider EM universe this year (see chart), and has taken another big hit over the past two weeks as the slowing Chinese economy has hit commodity prices. Investors will therefore have to go about carefully in picking their stocks.