Keep Calm And Add More Carry by Russ Koesterich, CFA – BlackRock
The prospect of lower stock returns and higher volatility going forward suggests for Russ that investors should consider strategies such as carry, or yield, to boost risk adjusted returns.
Twenty years ago investing was much easier. Between 1995 and 1999 the S&P 500 staged a remarkable streak of five straight years in which total return exceeded 20 percent. But that period was followed by a prolonged period of subpar returns.
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Is history repeating itself? Few would confuse the last seven years with the late 1990s, but equities, particularly U.S. stocks, have once again been producing outsized returns. Even including 2015’s flat performance, between 2009 and 2015 the average price return on the S&P 500 was nearly 13 percent. This is unlikely to hold over the next seven years.
But if price appreciation becomes harder to come by, investors need to consider the role of positive cash flow, whether through dividends, or yields. This is referred to as “carry” by financial professionals. Three trends support the case for a greater focus on carry in a portfolio:
Lower equity returns
The BlackRock Investment Institute forecasts just 4.3 percent annual returns for domestic large-cap stocks over the next five years, mostly due to elevated valuations. Today the S&P 500 trades at roughly 19 times trailing earnings. Small cap valuations are even more elevated, with the Russell 2000 trading at over 35 times trailing earnings. In our opinion, this bodes poorly for future long-term returns. Other markets, notably emerging markets (EMs), are likely to perform better thanks to much lower valuations. However, EMs come with considerably more risk, a problem for more conservative investors.
While volatility has been on the rise since last August, much of the past five years has been characterized by unusually low volatility. Today the VIX Index is around 15, roughly 25 percent below the long-term average. Looking at the futures curve for the index, investors expect volatility to rise back to around 20 by the fall. Even this may understate the potential rise in volatility. Volatility normally moves in tandem with credit markets. While financial market conditions have become easier, evidenced by tighter spreads, they are still considerably tighter than was the case two years ago. This suggests that volatility should rise back into the low to mid-20s.
Yields on U.S. Treasuries continue to defy expectations, remaining near multi-decade lows. However, the spread on corporate bonds, i.e. the incremental return over Treasuries, has widened in recent years. For example, while high yield spreads are considerably lower than they were at the January market bottom, they are approximately 200 basis points (2 percent) wider than they were two years ago, as Bloomberg data shows. Although corporate defaults are also on the rise, investors are being compensated for taking incremental risk in credit markets.
Where does this leave investors?
To the extent investors are trying to maximize risk-adjusted returns, in our view, parts of the credit market look attractive, at least relative to U.S. stocks. Based on BlackRock’s long-term assumptions, some of the better return-to-risk ratios are in high yield bonds, EM dollar-denominated debt and bank loans. International stocks also look attractive relative to domestic ones thanks to lower valuations and generally higher dividend yields. Another potential asset class that scores well on expected yield relative to expected risk: preferred stocks. According to Bloomberg data, a broad basket of preferred stock currently yields around 5 percent with modest single digit volatility.
Based on our research, none of these asset classes are likely to produce the same type of double-digit returns that investors have enjoyed in recent years. But adding carry can help boost returns—or cushion a portfolio—at a time when returns will be harder to come by. This is probably not the right point in the cycle to try to replicate the halcyon days of the late 1990s.