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The US cash rate, at 0.25%, is close to zero, even if the Federal Reserve might raise the rate again soon. Central banks in the eurozone and Japan are using unconventional policies such as negative interest rates to battle deflation and economic lethargy. Yet the result of such loose monetary policy is weak global growth.
Given the ineffectiveness – and possible nasty side effects – of radical monetary policies, policymakers are thinking of turning to fiscal stimulus to prod their economies. Such a spur will be curtailed by the fact that governments are already saddled with high debts. Yet at the same time, less-extreme monetary policy will remove the prop that has boosted bonds and equity prices in recent years.
That prospect raises the question about how an investor might achieve an adequate real return (say 5 percentage points above inflation), especially in an environment where bonds and the proxies investors have used to chase yield are likely to be more challenged than equities. The answer partly comes down to exploiting the role that cyclical volatility plays on financial markets.
Cyclical volatility is a way to describe the medium-term price movements around the longer-term returns produced by different asset classes. Such variations are normal in financial markets. They can be significant in magnitude and they can endure for relatively extended periods, say up to five years in some cases.
The volatile nature of returns reinforces the idea that returns are not linear. Even within “bear” markets, significant rallies are likely. As a consequence, investors who can participate in the cyclical rallies but who can avoid much of the inevitable downswings can achieve decent returns. In contrast, in “bull” markets, cyclical volatility is less relevant as set-and-forget strategies based on achieving the longer-term market return will prove adequate.
Thus, the art to achieving real returns in today’s world largely comes down to timing shifts between asset classes to capture the upside of this cyclical volatility while attempting to avoid losses. To be sure, piling into assets when they are rising and pulling back when they are falling is easier said than done. But it can be done.
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Cyclical volatility is largely driven by two interrelated factors: changes in valuations and the rotation of the business cycle. Our approach is effectively to mesh the long-run return of assets with shorter-run valuation dynamics to produce medium-term (i.e. three-year) return forecasts. We then overlay this with an assessment of where we are in the business cycle and what this means for asset-price behaviour and policy. While by no means perfect, this provides us with a framework within which we attempt to buy assets when the risk of a capital loss is low and return prospects high and to sell when risk of a capital loss is high.
Our central investment case for the next three years is that we expect equity markets to deliver reasonable returns. The opposite, however, is true with bond markets and assets that have benefited excessively from the decline in bond yields such as equities with relatively stable income streams such as A-REITs. Bonds and these bond proxies are expected to struggle or deliver negative, but very low negative, returns in coming years. This outlook provides us with some guidelines in our quest to deliver adequate real returns in coming years.
1. Which market and when will be crucial: Market performance will be vital in delivering real returns in coming years. Appropriate and potentially aggressive shifts in asset allocation will be needed to capture the upside and, more significantly, to avoid giving away gains as markets decline. This is another way of saying active management will be crucial.
2. The sovereign bond outlook looks poor: Until appropriate risk is attached to bond prices and monetary policies move towards more normal settings, the sovereign bond outlook looks ordinary at best. While equities may struggle as bond yields rise, overall we expect better returns from equities than bonds.
3. Assets linked to declining bond yields are at risk: The most problematic assets are likely to be strategies where performance is tied to the decline in bond yields. At an asset-class level, these investments include sovereign bonds, infrastructure and real estate investment trusts.
4. Structured/alternative market-based strategies and complex financial engineering require caution: We remain cynical about alternatives, particularly when market pricing has been heavily distorted by central-bank policies. Alternative assets, especially hedge funds, have historically over-promised and under-delivered. While conceptually, it is logical to consider alternative assets in a world where returns from equities and bonds are likely to be constrained, stepping down this path is unlikely to solve the low-return problem in the medium to longer term.
5. Using debt to maximise returns brings additional risk and may not solve the fundamental problem of low returns: With respect to the pursuit of non-directional active-based  strategies, investors should be aware that these are for the most part relative value trades and those that require leverage to implement and considerable skill to identify. There’s often more market-related risk in these strategies than there appears to be.
6. Transparency, liquidity and the ability to hold cash will be important elements of a successful strategy: Low bond yields reduce diversification because they expose a greater part of the portfolio to the risk of higher interest rates. The way to mitigate this is to reduce equity holdings, make more aggressive use of lower-risk equity substitutes and hold more cash than would be the case traditionally.
7. Active asset management within asset classes will be important. Stock selection will be important.
In conclusion, there is no doubt that achieving CPI+5% consistently against this backdrop will be tough. While the risk to delivering our return objective consistently is to the downside, minimising losses and maximising the returns to be gained during market upswings will be paramount.
Originally published by Simon Doyle, Head of Fixed Income & Multi-Asset, Schroders

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