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August 2019 | Macro Insights

Building Income in a Volatile Market

Market volatility, historically low interest rates, full valuations, and unprecedented monetary policy: Each is a reminder that investors may need to work harder to generate attractive returns in the future. At a time when the outlook for major asset classes strikes us as average at best, income generation may be one answer for investors who worry that they are too reliant on a continuation of the sharp gains of the post-financial crisis period.

Here are the reasons we think market returns may be muted in the future, starting with equities. In the past, when equity valuations have stood in the 9th or 10th deciles measured by the cyclically adjusted price-to-earnings (CAPE) ratio, as they do today, 10-year subsequent equity returns historically have been average and in some cases low, at an annualized 7.4% in the 9th decile and 2.1% in the 10th.

Fixed income yields alone, in our view, are indicative of pedestrian returns in the future, with the yield on the 10-year US Treasury near its historical three-year low of 1.65% as of mid-August. This state of affairs has inspired commentators to make favorable comparisons of equity yields to meager Treasury bond yields.

EXHIBIT 1: CAPE Fear

Chart Notes: Bloomberg, Robert Shiller, and GSAM. As of July 31, 2019. ‘CAPE ratio’ refers to the cyclically adjusted price-to-earnings ratio, which is a valuation measure using real earnings per share (EPS). ‘10-year Avg. Sub. Return’ references monthly returns of the S&P 500 Total Return Index. Table shows the CAPE ratio in deciles, from lowest to highest, and its respective average returns over the next 10 years. Past performance does not guarantee future results, which may vary. The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this document. 

Substituting income-generating strategies for efforts to capture pure price returns could be an attractive possible answer to these dilemmas. In particular, we think well-diversified, conservatively positioned strategies with lower volatility than the equity market may be worth revisiting, since they depend upon cash flow potential as a larger component of total return.

We see demographics as another driver of greater structural interest in these strategies. As the Boomer generation ages in a period of low interest rates, more Americans will need to reach farther afield to achieve the typical 4.0% portfolio distribution to sustain their standards of living in retirement. There is no escaping the fact that, in 1991, a 50/50 stock/bond portfolio would have generated yields of 7.2% (a generational high), but even in this past month, the yield of the same portfolio had dropped to 0.8%.1

Spreading risk across a range of yield-oriented asset classes could be a potential corrective. For instance, adding a mix of cash flow enhancers such as Global Infrastructure and MLPs, Buy-Write strategies and Emerging Market Debt is one way to unlock 4% or greater annual distribution potential.

Lower risk than conventional equities, higher yield potential, and diversification: These features strike us as an attractive combination for the current market environment.

EXHIBIT 2: CASH FLOW ENHANCERS MAY HELP GENERATE INCOME

Chart Notes: Bloomberg Barclays, Morningstar, and GSAM. As of July 31, 2019. ‘Global Infra. And MLPs’ refers to Global Infrastructure and MLPs. With the exception of the ‘US 10-Year Treasury’, distribution yield assumptions represent the asset-weighted median 12-month distribution of Institutional or No-Load Shares of mutual funds in the representative Morningstar category, excluding those funds with 12-b(1) fees greater than 0.25%. In an effort to distinguish funds by what they own, as well as by their prospectus objectives and styles, Morningstar developed the Morningstar Categories. While the prospectus objective identifies a fund’s investment goals based on the wording in the fund prospectus, the Morningstar Category identifies funds based on their actual investment styles as measured by their underlying portfolio holdings (portfolio and other statistics over the past three years). Please see additional disclosures at the end of this document.

1 Source: Bloomberg Barclays and Goldman Sachs Asset Management, as of July 31, 2019. The 50/50 stock/bond portfolio is represented by the total monthly return of the S&P 500 Index and the Bloomberg Barclays Aggregate Bond Index, from February 1988 through July 2019. Past performance does not guarantee future results, which may vary.

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ABOUT THE AUTHOR

John Tousley

John Tousley

Global Head of Market Strategy, Strategic Advisory Solutions, Goldman Sachs Asset Management