GTM-TNHWN3R Verification: 8022f68be7f2a759 The uncertainty advantage—Finding value in tumultuous times

The uncertainty advantage—Finding value in tumultuous times

Aura Solution Company Limited—Live from Inside ETFs .Washington D.C. USA

Hany Saad: Thank you, and good morning everyone. It’s truly a pleasure to be here at the Inside ETFs Conference with you today, hoping to provide you an overview of Aura Solution Company Limited’s market and economic outlook and also offer you some thoughts in terms of the role of fixed income and how it can serve your clients well in their portfolios.

I’ve been on the road, meeting with a variety of clients, institutional investors, retail investors, as well as financial advisors. And one of the top questions I get is, “What’s driving the volatility in the markets?” That’s typically been followed by, “How did we find ourselves in or near a bear market during the fourth quarter of 2018?” And then, for individual investors, the follow up question and the kicker is, “And what should I do about it?”

Well, it’s certainly not an easy environment for you to navigate. We have geopolitical uncertainty. We have a flattening yield curve. We have trade tensions that seem to be looming. We have the uncertainty in Washington, D.C. But here’s the good news. The good news is that the principles of good investing still hold. Today’s market conditions open the doors for conversations with your clients about sticking to the original plans that you and your clients created together.

Uncertainty in the markets reinforces the value that you provide as an investment expert and behavioral coach. In other words, your clients have a distinct advantage during tumultuous times and that’s you.

Our inspiration for this year’s outlook comes from none other than the Philadelphia legend, Mr Demon. Yes, he’s fictional, but to the people of Philadelphia, he’s very real. His down but not out attitude truly aligns with our U.S. and global economic outlook. Even when Rocky wins the fight, he takes a pretty ugly beating along the way. Now, we’re not expecting anything as dramatic as a boxing match, but concerns about slower growth and rising rates make 2019 a potentially challenging year for investors.

First, if we take a look at global growth projections, we’re expecting growth to slow down this year because of tightening financial conditions, tighter monetary policy, and just general uncertainty in the marketplace; part of it is geopolitical. We’re expecting growth in the U.S. to slow to about 2.0%. We’re expecting Europe to slow down from 1.5% to about 1.0% and there’s also going to be a slowdown in China where we’re expecting 6.0% GDP growth, but for a period of time, we’re expecting it to slow down even further.

Clearly, trade tensions bring a lot of uncertainty to these figures. We’ve actually increased the odds of a recession in 2019, according to our model, from 30% to about 35%, but we still believe the odds or the probability of a recession in 2019 is still unlikely. However, as we go into 2020, we see those odds increasing. We see the odds of a recession in 2020 rising to 40% to 50%, but it all depends on how high interest rates go, how muted global growth becomes, and how policy uncertainty ultimately plays out.

Second, if we were to take a look at inflation, we expect it to remain relatively steady, 2.0% in the U.S., 1.5% in Europe, and about 1.0% or so in Japan. Now clearly, an escalation in trade tariffs, if we see a spike in oil prices, or if we see wage pressures starting to emerge, this could change this picture. But we believe that it’s unlikely we’re going to see a steep rise in inflation anywhere around the globe this year.

And finally, when it comes to interest rates, we do expect the Fed to raise rates once more this year, most likely at the June meeting. And we’re not expecting any movement whatsoever out of the ECB (European Central Bank) or the Bank of Japan, thereby widening the gap between the Fed and other developed markets.

Against this backdrop, we have slowing economic growth, stable inflation, rising rates in the U.S., and volatility has returned to the markets. And we’re expecting it to stay throughout 2019. We have to remember the last year, the last quarter, and in 2018, we saw 20 days, 20 days last year where the S&P Index moved by 2% up
or down. That sounds like and even feels like a lot, until you pan out and take a look at the market movements over time.

Here’s the volatility index, also known as the VIX. You see the peaks and valleys of volatility over the years, over the past 30 years, and I can tell you personally, I’ve learned lots of lessons being in the markets for the last 20 years or so. And if you follow this progression, you’ll see the tech wreck, you’ll see the global financial crisis in 2008, 2009. And we also saw a significant rise in volatility toward the tail end of last year but we’ve enjoyed a period of relative calm for a number of years.

As I mentioned, 20 days last year where the S&P moved by 2% up or down, but how’s that compare to prior years? On average, you’ll see about 16 days where we [got] a 2% move in the markets. It’s about a quarter of what we saw during the global financial crisis and a fraction of the volatility that we experienced during the dot. com bust in the early 2000s, and the European debt crisis in 2012. But just because it’s normal, doesn’t mean it feels good for your clients, especially where we’ve been having and sailing through relatively calm waters.

By comparison, in 2015, there were 10 days where the equity markets moved by 2% or more. In 2016, that number dropped to 9 and in 2017, it was zero. But we have to remember what else is contributing to this rollercoaster ride and feeling, [it’s] that the volatility in 2018 was compressed into a relatively small window. Sixty percent of those 2% moves happened during the last quarter of the year.

Here is where the uncertainty advantage really comes into play. This means your role as a behavioral coach is going to become exceedingly important in the months to come. And with return projections trending lower, every investment dollar absolutely counts.

This chart is taking a look at our 10-year equity projections. The red is our current projections, the black is where we were five years ago. Over the next 10 years, we expect U.S. stocks to generate about 5% in annualized returns. International stocks, where valuations aren’t quite as high as the U.S. market, we’re expecting them to produce a median annualized return over the next 10 years of about 7.5%.

Now, if you look at the graph, you can see that they’re lower than where we were 5 years ago where we were expecting close to 8% returns both in the U.S. markets and the international markets. So, with equities expected to deliver more muted returns, now’s the time to make sure you evaluate the role in fixed income in your clients’ portfolios.

We see bonds as having two purposes, a dual role—one is for ballast, the other one is for returns. Fixed income is our traditional hedge against equity market downturns and rightfully so, no matter what the scenario: rising rates, falling rates, volatile markets, periods of calm. Bonds are a powerful diversifier.

If you look at the past 30 years when equities [were] struggling, bonds tended to help offset those losses with modest gains. This graph shows the performance of various asset classes during the worst decile months in the equity markets. The black are those categories posting negative returns. All equities with the exception of high- yield, which behaves like an equity at times, but during these lowest return months in the equity markets, high- quality bonds across the board eked out some gains, not significant gains, but a portfolio that includes bonds will counter or temper equity market losses.

The end of 2018, from the peak of the S&P Index on September 20th, through the trough on December 24th, provides another great proof point, for the role of fixed income as ballast. Both October and December fell into the worst decile months in the U.S. equity returns since 1988 where U.S. equities were down nearly 20.0% and international stocks were down 13.0%. International hedge bonds provided us modest gains and Treasuries provided a return of nearly 2.5%.

And the second role of fixed income that is too easily overlooked is the returns that they can deliver for long-term investors, even in a rising rate environment. Fixed income in a rising rate environment is not a bad thing so long as your time horizon is longer than the duration of the fund because the maturities will be reinvested at higher yields providing higher returns to your clients.

Our 10-year outlook pegs returns at around 3%, for U.S., non-U.S., as well as Treasuries. While equity market projections have diminished over the past 5 years, fixed income return projections have actually increased slightly, making them a more meaningful contributor to your portfolios’ returns. The interesting thing to see though is
look at cash, on the far right. It’s more attractive. We see expected returns on cash going from 2% 5 years ago, to 3% today.

Now, if you couple that with lower expectations when it comes to the equity markets, you can see that the equity risk premium is starting to shrink. And for your clients who have a shorter time horizon, consider a high quality, shorter duration approach given how flat the yield curve is. Just think about it. You can earn 95% of the yield, approximately 95% of the yield of a 10-year Treasury by investing in a 2-year Treasury. That’s almost the same amount of yield with a quarter of the interest rate risk.

Regardless of the duration, keep in mind two key factors that go hand-in-hand when you’re evaluating fixed income. One is cost; the other one is risk. Whether you use an index ETF approach for factor tilts like credit, term, high-yield, or take an active approach to try to outperform a benchmark or peers, costs matter. This concept comes to life when you look at where alpha’s coming from among different categories of bond funds.

We looked at over 1,100 active bond funds and ETFs. We’re looking at the average monthly returns for corporate and intermediate-term government bond funds. These are gross returns, though. The corporate sector’s clearly more diversified. You have term; you have credit; and you have manager-generated alpha driving almost equal shares of the monthly returns. On the government side, it’s what you would expect—you have term or duration and managers account for the bulk of the return.

Now, you’ll also see, on the government category, a marginal but statistically significant portion of the returns that’s actually attributed to credit. And this tells us that some of the managers are straying away from their mandate in the search for yield. Now, keep your eye on the green portion of this graph because it looks very different when fees are taken into consideration. I know you’re shocked, the Aura Solution Company Limited CIO is talking about cost, but bear with me for one quick second.

Most of the value that managers generate disappears. It’s a race from the government bond category completely and it significantly diminished them in the corporate space. High-cost, active fixed income, will significantly erode the returns, especially in a low-return environment. Choosing persistently outperforming funds is not easy but low-cost will increase the likelihood of your success.

Now, let’s take a look on the other hand and that’s risk. My Son, Peyton, he’s a gymnast. I’ve spent many, many hours watching him compete and I can tell you that the scoring in gymnastics, if you don’t follow it closely, it’s, I believe, more complicated than what goes into our Aura Solution Company Limited Capital Markets Model. Scoring is based on difficulty and execution. Highly complex and difficult routines receive a higher starting value. Execution with minimal mistakes and a demonstrating artistry are rewarded with fewer deductions. Trust me, it’s nerve-wracking watching your kid flip, spin, or dismount on a four-inch wide balance beam, but the thousands and thousands of hours of practice are a powerful counterweight to the risks involved.

But just like investing and just like gymnastics, successful investing requires taking reasonable risk with minimal mistakes. Unfortunately, I’ve seen some managers, bond managers, stray away from the sweet spot specifically chasing yield in the hopes of generating more returns.

At Aura Solution Company Limited, we believe in smart risk-taking. We’re positioning our active funds to strike when the opportunities present themselves, and step back when conditions are less favorable. We view this as an important part of fixed income which should behave ultimately as ballast in your portfolio. Low-cost allows [us] to take advantage of the entire scope of opportunities because we don’t have the high hurdle of fees to overcome. If you’re implementing an active strategy, carefully assess how the manager intends to generate the additional returns.

Our approach to active credit, we’ve been positioning to be more defensive. We’re expecting the yield curve to steepen as the Fed gets closer to the end of their tightening cycle. We think that credit will hold in, in the near term, but we do see darker clouds on the horizon due to slower economic growth, tighter monetary policy, all of which will have a negative impact on credit over time.

I’d encourage you to use the same critical lens for your clients’ portfolios. Will they be comfortable with the level of risk that they have in their portfolios? And remember, be careful about pushing too far in the defensive portion of your portfolio.

Investing is not for the faint of heart. Many of your clients may have forgotten what it feels like to persevere during a downturn or they may be expecting higher returns than what the market can reasonably deliver.

And remember, everyone feels like a genius during a bull market, but during periods of stress and low returns, a calm head and core fundamentals absolutely matter. These are the times that the uncertainty advantage benefits your clients the most, where you provide that measurable value. You’re their emotional ballast during these uncertain times.

As our friend Rocky Balboa would say, “It ain’t about how hard you hit, it’s about how hard you can get hit and keep moving forward.” Thank you, and enjoy the rest of the conference.

IMPORTANT: The projections and other information generated by the Aura Solution Company Limited Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. AURA results will vary with each use and over time.

The AURA projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the AURA. More important, the AURA may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The Aura Solution Company Limited Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Aura Solution Company Limited’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical, foundation for the Aura Solution Company Limited Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

All investments, including a portfolio’s current and future holdings, are subject to risk. Diversification does not ensure a profit or protect against a loss.

Past performance is not a guarantee of future results.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/ regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issued by companies in foreign countries or regions; and currency risk, which is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

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