By Gregory van Inwegen, Global Head of Quantitative Research and Asset Allocation, Citi Investment ManagementParul Gupta, Global Head of Strategic Asset Allocation
July 21, 2016
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Estimating returns is a vital part of the asset allocation process. Here’s how our equity return estimates are made.
Over the next ten years, equities from emerging markets could outperform those from developed markets.
That’s the message of Citi Private Bank’s own strategic asset allocation methodology. It estimates that emerging equities could deliver an annualized total return of 10.4% between now and 2026. By comparison, it estimates an annualized total return of 6.0% for developed equities over the same period. But how does it reach these estimates?
Our methodology’s annualized estimates of returns for each asset class are called Strategic Return estimates (SREs). They’re based on valuations and other fundamental factors, depending on the asset class involved. For equity SREs, it considers:
- Current valuations compared to long-term average valuations
- Dividend yield
- Long-term earnings growth
- Currency effect
Let’s look at each of these to see how the calculation actually works.
To measure valuation, we use the cyclically-adjusted price-to-earnings ratio or CAPE. Comparing today’s CAPE with the long-term average CAPE helps determine whether equities’ valuations are currently high or low. Over time, high valuations have tended to give way to low returns and low returns to high returns. Our methodology reflects this in its SREs.
At the moment, developed equities trade on a CAPE of 24.9, compared to its long-term median of 21.5. Based on the long-established pattern, our methodology assumes it will revert to its long-term median over the coming decade. And we estimate that this will negatively affect developed equities’ returns by 2% a year for this period – see figure 1.
The next part of the return comes from the dividend yield. For both emerging and developed equities, we assume a positive contribution to SREs of 2.1% a year. Next, we assume earnings growth will enhance the returns of both in line with their respective long-term averages.
The final factor is currency movements. Our methodology estimates that the US dollar will go down against other developed-market currencies over the next decade. That would mean a small annualized boost of 0.1% for developed equities’ SRE over this time. But it estimates a rise in the dollar against emerging countries’ currencies, which could cause a 2.4% yearly drag on emerging equities’ SRE.
Having established SREs and estimates of risk, our methodology then uses them to help produce strategic asset allocations. These allocations are the cornerstone of the portfolios that we build for clients. For our strategic return estimates covering ten broad asset classes, please see Adaptive Valuation Strategies - 2016.
Source: Citi Private Bank Global Asset Allocation Team. SREs for 2016; based on data as of October 31, 2015. All forecasts are expressions of opinion and are not intended to be a guarantee of future results. Strategic Return Estimates are no guarantee of future results.