Jeff Knight Answers Key Questions About His Recent 5-Year Forecast

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by: Columbia Threadneedle Investments

By Columbia Threadneedle Investment Team

Jeff Knight and the Global Asset Allocation Team recently released an updated five-year forecast of returns for major asset classes. And many of you responded.

Some of you thought our forecast was optimistic. Some just wanted to verify what was behind the numbers. Whatever the angle, the intensity of the response is a sign of the times.

Investors are facing a challenge: Things have been good for a long time, as evidenced by the eight-year long bull market in equities. And the instinctive concern that all good things must come to an end is difficult to ignore. If you make investment decisions based on that fear alone and make your portfolio more conservative too early, you risk missing out if the good times continue. But ignoring your concerns completely could wind up being too risky.

So, as many of you turned to the five-year return forecast for some insight, Jeff Knight answered some of your most common questions.

Q: Your forecasted returns are positive, but did your analysis consider scenarios where they would be less positive?

Jeff Knight: When we publish our forecasted five-year returns, we represent them as a bar chart, and we include an expected return percentage for each asset class. It's a useful way to make the analysis practicable.

However, if we only focus on a single return expectation, we miss some of the richness and depth of the exercise. When we develop our forecast, we think about the different ways conditions could evolve and we develop several market scenarios. This year, each of the possible scenarios has a dependency on policy, including decisions regarding fiscal policy, tax policy, business regulation and monetary policy. Our most likely scenario assumes that policy changes occur with a decisive advantage to businesses. Our less likely scenario assumes that whatever changes do occur end up being too marginal to deliver these benefits. Finally, our least likely scenario assumes that whatever policy decisions transpire end up - whether by design or by accident - actually delivering negative consequences to economic growth, business prosperity and financial markets. We assigned each scenario a probability of 60%, 30% and 10%, respectively.

Q: Is it possible the forecasted five-year total annual returns for the major asset classes could be negative?

Jeff Knight: Ah yes, this is the most frequently asked question about these forecasts. Let me respond first with two technical points. First, a negative total return from the S&P 500 Index over a five-year holding period rarely occurs. Since 1875, a proxy for the U.S. equity market and the S&P 500 Index has delivered negative returns in only 12% of overlapping five-year holding periods.*

The second point relates to the mathematics of forecasting. Our forecast represents the weighted average of a range of possible return experiences over the next five years based on the three scenarios referenced above. There's a pretty significant margin of error around that average that represents the uncertainty and variation inherent to financial markets. Although this next point is technical, it's important: The more imperfect our forecast, the less volatile our center point estimate will be. And the less volatile our center point estimate is, the less likely it will be to breach negative territory.

In order to generate a five-year central case forecast of negative returns, our inputs would have to be extremely dour. We would need to assume zero growth in earnings over the five-year period. We would also need to assume enough of a reduction in equity multiples to offset all of their accumulated dividends. Lastly, we would have to assume that multiples not only collapse, but never recover within the five-year period. Generating a negative return forecast would require all of these pessimistic assumptions. Certainly, this combination of misfortune is not impossible, but it hardly represents our central case. Even in our worst-case scenario, we would not predict negative returns over five years unless we foresaw another global financial crisis on the same scale as the 2008 crisis.

Q: With a good portion of 2017 behind you, what observations do you have looking back at your expectations at the beginning of the year?

Jeff Knight: The overall message from our forecasts at the beginning of the year was that equities offered a pronounced return advantage relative to bonds, and market outcomes this year conform nicely to that view.

That said, one of the most useful things about this process is paying attention to how our forecasts evolve every six months. The equity forecast remains solid, but it is lower than earlier this year. That's partly because equities have outperformed even our optimistic forecasts from the beginning of 2017, but also because our high hopes for significant business-friendly policy changes haven't exactly been gratified. We're now less optimistic that these policy changes will occur with the same intensity that we once expected, if they occur at all. As a result, we not only revised our central scenario down, but also reduced our probability weighting to this scenario.

Q: How should I view this forecast?

Jeff Knight: It's still a risk-taking world, but you can't just set it and forget it. As a multi-asset investor (and anyone who has a diversified portfolio is exactly that), you need to think about how asset classes interact with each other, not just how they will perform individually. Looking forward, strategies designed to stabilize portfolio values must expand beyond the simple inclusion of fixed income assets - both because forward-looking returns are lower than historical ones and because bonds and equities may increasingly respond to market dynamics in a similar way. Consider using investment solutions that include additional diversifiers like alternatives. The bottom line? Enhance diversification and stay flexible.

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*Source: Robert Shiller, Irrational Exuberance, data available here.

The Standard & Poor’s (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks. It is not possible to invest directly in an index.

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