%
10.1
Equities:
Asia
ex-Japan
%
6.0%
Autumn 2015
Equities: US
Equities: EU
10.3%*
10-year
average annual
expected
returns
WITH INNOVATION
SHOCK:
UP TO +4.3%
Horizon
WITHOUT INNOVATION SHOCK
5.8
%
9.7
%
7.4
Private
equity:
real
estate
8.0%
8.0%
0.1%
-0.1%
8.0%
5.4
5.2 %
%
%
1.6
2.1%
Corporate
bonds:
US
high-yield
Corporate
bonds:
EU high-yield
%
%
3.8%
3.6%
Corporate bonds:
EU investment-grade
3.9
3.3
Government bonds:
US Treasuries
1.7%
%
1.8
1.6
%
1.7
%
Government
bonds:
German Bunds
8.2%
Cash: US
Corporate bonds:
US investment-grade
Cash: EU
Expected returns without innovation shock*
Expected returns with innovation shock*
“A key stage in wealth planning is
calculating the expected long-term returns
of the various asset classes.We have
developed a proprietary risk factor-based
approach that forecasts returns over a
10-year horizon. In our baseline scenario,
a radical innovation shock boosts
economic growth and creates a fairly
strong outlook for expected returns.
In the absence of such a shock, expected
returns are more muted under our
secondary scenario for a gradual
normalisation of economic growth.”
*Average annualised nominal returns, in local
currencies, with coupons and dividends reinvested
Page 3
FOREWORD
Expected returns for asset
classes over the next ten
years are low in a historical
comparison based on current
trends—but an innovation
shock could radically alter
the picture.
Dear Reader,
This edition of Horizon presents our latest
calculations for expected returns on asset classes
over the next ten years. Our unique methodology
is based on our finding that in the very long
run returns are chiefly influenced by real GDP
growth and inflation.
If we assume a gradual normalisation of
economic growth, expected returns on almost
all asset classes look disappointing in a historical
comparison. Returns on US equities for example
are projected at 6.0% on a nominal average
annual basis over the next ten years, compared
with 8.9% during 1871-2015. Investors now face
the challenge of continuing to generate decent
returns as long-term interest rates normalise—
there is no longer any ‘free lunch’.
Lower expected returns partly reflect a
sluggish outlook for economic growth. Some
economists even argue that the developed
world faces a future of ‘secular stagnation’,
but we are sceptical.This is partly because the
idea underplays the role of cyclical factors in
weak growth following the 2008-09 financial
and economic crisis—our secondary scenario
is therefore for economic growth gradually
to normalise. But we also think there are
increasingly signs of a radical innovation
shock that could boost productivity and hence
Page 4
economic growth—this forms our baseline
scenario.
A wave of innovation is under way, most notably
Silicon Valley, that could soon unleash radical
transformation across the economy—the
Internet of Things is a potent example. What
would this mean for investors? Expected returns
would generally receive a significant boost in the
event of a radical innovation shock, especially for
equities—returns on US equities would jump to
10.3%. Moreover, there would be opportunities
for investment strategies to evolve along the
S-curve of the innovation cycle.
We see parallels with the 1990s, when the
advent of new computing and communications
technologies propelled US real GDP growth to
3.5%, well above the country’s 2.5% long-term
equilibrium growth rate. We may indeed already
be well into the early stage of the innovation
cycle, which could be compared with 1990-95.
In this environment, stock-picking of companies
strongly exposed to the new innovations could
be rewarding.
This approach could continue during the
acceleration phase (think 1996-2000). But early
birds will be subject to a brutal process of
Darwinian selection as competition heats up.
Compare two companies listed in the 1990s:
Amazon and Sycamore (fibre optic network
equipment). Amazon’s success is well known.
Sycamore had a market capitalisation of
USD20bn by the end of the 1990s. However, its
quarterly earnings were barely USD14m and, in
contrast to Amazon, the company was wiped out
in the ensuing tech crash. Investment in techoriented indices like the Nasdaq could also reap
rewards at this stage.
In the mature phase, stock-market indices will
have reached excess or even bubble territory
and are liable to crash or at least correct sharply
(think 2001-2002 and the bursting of the dotcom
bubble). More defensive strategies at this stage
could involve a shift from innovation-sensitive
equities to value stocks.
The timing of innovation shocks is far from
certain. Nevertheless, we are encouraged by the
tendency through economic history for positive
shocks to follow negative ones, and think that
innovation will once again drive economic
growth onto a higher plane.
Horizon – Autumn 2015
EXECUTIVE SUMMARY
We have updated our estimates
of expected returns from the
main asset classes in each of
the three main economic blocs.
The calculations are made on
the basis of our macroeconomic
analysis for the starting- and endpoint regimes of growth and
inflation—the two key risk factors
determining long-term returns on
assets. We consider two scenarios:
regimes under an innovation
shock that boosts economic
growth (our baseline scenario),
and regimes with no innovation
shock, and hence a progressive
normalisation of economic
growth and inflation (our
secondary scenario). Our main
findings are presented below.
Expected long-term returns have risen for
equities and US high-yield. Expected returns
from equities rise compared with our forecasts
in April 2014, to 10.3% for US equities under the
baseline (see page 6). Expected returns for
US high-yield corporate bonds have also risen. For
cash, expected returns are broadly unchanged. For
most other assets, expected returns have fallen.
This is most notably the case for government
bonds and European investment-grade corporate
bonds. Expected returns from private equity
decline slightly. Despite this, the highest expected
returns from all asset classes continue to be from
private equity, at 13% under both scenarios (with
and without innovation shock).
Returns are mostly lower in a historical
comparison. Expected returns for almost
all asset classes are lower than in a historical
comparison—in many cases substantially so (see
page 8).This deterioration reflects the fact that
valuations are stretched. In this environment
of relatively low expected returns across most
major asset classes, a traditional 60/40 portfolio
(60% equities, 40% government bonds) would
return just 6.9% annually with an innovation
shock and 4.2% without, on our calculations
(assuming a split between the S&P500 and US
Treasuries), compared with 10.9% in 1981-2012.
Generating higher returns will mean accepting
higher risk.
The idea of secular stagnation underplays
the potential for innovation to boost
growth. Some economists argue that, as a
result of structural constraints, trend economic
growth in developed economies has fallen to
permanently lower level. We agree that structural
headwinds to growth have risen, but think that
the concept of secular stagnation underplays
cyclical factors and ignores the potential for
innovation to boost growth (see page 10).
Under our secondary scenario, without an
innovation shock, growth and inflation
would gradually normalise in standard regimes
(economic growth of around 2.5% and inflation
of around 2% for the US).
A radical innovation shock may be set to
emerge. Genuine technological revolutions
take time to feed through to deliver tangible
and sustainable benefits to economic growth.
But signs of such a revolution are mounting, and
this underpins our baseline scenario of a radical
innovation shock (see page 11). Indeed, we may
already be close to the end of the early-cycle
phase and poised to enter the acceleration phase.
A radical innovation shock would deliver a longlasting boost to economic growth, moving
the main economies to a high-growth regime
(for example US trend economic growth
would rise to 4%).
Investment strategies should evolve along
the S-curve. A stock-picking approach is bestsuited to the early-cycle phase, as innovators
pursue stock-market listings. During the
acceleration phase, as take-up of the innovation
accelerates throughout the economy, pushing
economic growth onto a higher plane,
investment in stock-market indices can prove
rewarding. During the maturity phase, when
indices are liable to correct or crash, a switch
to more defensive strategies is called for, with a
focus on value and defensive stocks rather than
those exposed to the innovation (see page 12).
The Internet of Things (IoT) is moving from
hype to investment reality. The evolution
of the IoT provides an important example of
the way that trends in innovation and technology
are rapidly coalescing to create a potentially
revolutionary impact (see page 14).The IoT
could comprise over 25 billion devices. Lower
device costs, ubiquitous connectivity, and energy
efficiency are driving its emergence. From an
investment standpoint, the winners and losers
in a hyperconnected IoT world are starting
to emerge.
Page 5
I. Expected returns from
asset classes
We have updated our estimates of expected
returns from the main asset classes in each of
the three main economic blocs. The calculations
are made on the basis of our macroeconomic
analysis for the starting and end-point regimes
of growth and inflation—the two key risk
factors determining long-term returns on assets.
We consider two scenarios: regimes under a
radical innovation shock that boosts economic
growth (baseline scenario); and regimes with
no innovation shock, and hence a progressive
normalisation of economic growth and inflation (secondary scenario).
Expected long-term returns have risen for
equities and US high-yield
Expected returns from equities have increased
under both scenarios compared with our estimates in April 2014, owing to below long-term
trend performance in US and European indices
over the past year. Under the scenario with an
innovation shock, nominal average annual returns
over the next ten years rise from 8.2% to 10.1%
for European equities and from 7.8% to 10.3% for
US equities.The sensitivity of expected return is
greater in the innovation shock framework—thus
an insignificant variation under the baseline translates into a meaningful increase in this scenario.
Expected returns for US high-yield corporate
bonds have risen, from 6.5% to 8.2% under the
baseline and from 6.1% to 8.0% without an innovation shock, owing to a more favourable base
effect. However, in the US a high proportion of
this asset class is comprised of energy companies.
While these offer good value at present, there is
also a significant risk of value traps, given the uncertain outlook for the energy sector. Moreover,
high-yield corporate bonds typically have a considerably lower duration than investment-grade
EXPECTED RETURNS FROM ASSET CLASSES WITH AN INNOVATION SHOCK AND WITH NO INNOVATION SHOCK
Interest rates
Corporate bonds
Equities
With innovation shock (baseline scenario)
Projection
(September 2015)*
Projection
(April 2014)*
2015-2025
2014-2024
Private equity
13.0%
15.0%
-2.0%
Equities: US
10.3%
7.8%
2.5%
Equities: EU
10.1%
8.2%
1.9%
Equities: Asia ex-Japan
9.7%
8.2%
1.5%
Private equity: real estate
8.0%
8.0%
0.0%
Corporate bonds: US high-yield
8.2%
6.5%
1.7%
Corporate bonds: EU high-yield
5.4%
5.2%
0.2%
Corporate bonds:
EU investment-grade
1.7%
3.1%
-1.4%
Corporate bonds:
US investment-grade
3.8%
3.8%
0.0%
Cash: US
3.9%
4.0%
-0.1%
Cash: EU
2.1%
N.A
N.A
Government bonds: US Treasuries
1.6%
2.6%
-1.0%
Government bonds: German Bunds
-0.1%
1.1%
-1.2%
* Average annualised nominal returns, in local currencies, with coupons and dividends reinvested.
Page 6
Horizon – Autumn 2015
Difference
or sovereign bonds, and reinvestment risk is
therefore higher.
For most other assets, expected returns have
fallen.This is most notably the case for
government bonds. Returns on German Bunds
are now flat or slightly negative, while returns
from US Treasuries have deteriorated from 2.6%
to 1.6% under the baseline and from 2.7% to
1.8% without an innovation shock. Again, this
reflects developments on markets since the last
update: yields are now starting from a lower
point.This is especially the case in Europe, where
yields on 10-year German Bunds reached a low
of 0.05% this year.The increase in interest rates
that we anticipate, in line with normalisation of
monetary policy, will reduce returns in terms of
price performance.
There has also been a marked deterioration
in expected returns for European investment-grade corporate bonds, from 3.1% to
1.7% in nominal annual average terms over the
ten-year forecast under the baseline, and from
2.8% to 1.6% without an innovation shock.This
represents a less favourable starting point: yields
on this asset class in Europe have fallen by over
50 basis points since April 2014, as one effect of
quantitative easing by the ECB has been to push
down borrowing costs for European corporates.
Yields on US investment-grade corporate bonds
by contrast have moved only slightly over the
past year.
For cash, expected returns are broadly unchanged. We still expect a normalisation of monetary policy, with developed-economy central
banks continuing to target inflation of around 2%.
Similarly, as our core macroeconomic scenario
remains the same, there is no alteration to expected returns from private equity real estate.
Expected returns from private equity decline
slightly, from 15% to 13% under either scenario,
as a result of recent outperformance. Despite
this, the highest expected returns from all asset
classes continue to be from private equity under
both scenarios (with and without innovation
shock). However, the extra incremental returns
offered by these asset classes need to be weighed
against their lack of liquidity.The full investment
cycle for private equity is seven to eight years,
Without innovation shock (secondary scenario)
Projection
(September 2015)*
Projection
(April 2014)*
Annualised historical
performance %
Annualised volatility %
2015-2025
2014-2024
2011-2015
2011-2015
13.0%
15.0%
-2.0%
–
–
6.0%
4.5%
1.5%
14.5%
14.8%
5.8%
4.5%
1.3%
11.8%
15.9%
7.4%
6.1%
1.3%
2.6%
15.7%
8.0%
8.0%
0.0%
N.A
N.A
8.0%
6.1%
1.9%
6.8%
3.4%
5.2%
4.8%
0.4%
9.1%
3.8%
1.6%
2.8%
-1.2%
5.4%
2.4%
3.6%
3.5%
0.1%
5.1%
4.2%
3.3%
3.4%
-0.1%
0.1%
0.0%
1.7%
N.A
N.A
0.3%
0.0%
1.8%
2.7%
-0.9%
4.9%
6.9%
0.1%
1.2%
-1.1%
7.3%
5.8%
Difference
Source: Pictet WM – AA&MR
Page 7
“The increase in interest rates
that we anticipate, in line with
normalisation of monetary
policy, will reduce returns on
government bonds in terms of
price performance.”
“Despite the issue of illiquidity,
the returns offered by private
equity and private equity real
estate make them a necessary
part of the asset allocation for
large portfolios.”
so the payback on this investment will only be
realised in full at the end of that period. As that
is an exceptionally long time to hold onto an
investment, investors tend to require a superior
return. Despite the issue of illiquidity, the returns
offered by private equity and private equity
real estate, in an environment of generally poor
expected returns across asset classes, make
them a necessary part of the asset allocation
for large portfolios.
not substantially so in the secondary scenario.
Returns from equities have typically been higher
historically as well, although since 2000 they
have lagged, as markets have suffered two major
crashes, the bursting of the dotcom bubble and
the subprime mortgage debacle—notwithstanding an outperformance by the S&P500 during the
rebound from those busts.Trends in bonds tend
to be less volatile than in equities—although
even for bonds, there can be significant variations in annual returns.
Returns are lower in a historical comparison
Under our baseline scenario (innovation shock),
equities perform well. However, in our secondary scenario almost all asset classes’ expected
returns are lower than in a historical comparison.
Returns on US equities for example are projected
at 6.0% on a nominal average annual basis over
the next ten years without an innovation shock,
compared with an average return of 8.9% in
1871-2015.This deterioration across asset classes
reflects the fact that valuations are somewhat
stretched.
In this environment of relatively low expected
returns from government bonds, a traditional
60/40 portfolio (60% equities, 40% government
bonds) would return 6.9% annually on average
with an innovation shock and 4.2% without,
on our calculations (assuming a split between
the S&P500 and US Treasuries), compared with
10.9% in 1981-2012.This deterioration is not a
new phenomenon: since peaking at around 16%
in the mid-1990s, returns on this asset allocation
have been on a declining trend.
Expected returns from equities are above
those for government bonds and for cash, but
The reason a 60/40 portfolio was able to deliver
double-digit returns for much of the past
EXPECTED RETURNS ARE GENERALLY BELOW HISTORICAL RETURNS (TOTAL RETURN IN LOCAL CURRENCY)
Historical return
Equities
8.9
US
2.9
EU
Asia ex-Japan
Bonds
9.4
9.7
7.4
10-year German Bund
2
4
2001 – 2015
10.1
5.8
0
1871 – 2015
10.3
6.0
6
8
1988 – 2015
10
12
7.3
-0.1
1980 – 2015
0.1
Cash Europe
1.7
10-year US T-Bonds
2.2
2.1
1999 – 2015
8.1
1.6
1.8
Corp. Investment Grade EU
1.6
5.4
1.7
2.6
Cash US
1980 – 2015
3.3
Corp. Investment Grade US
2000 – 2015
1997 – 2015
3.9
8.8
3.8
3.6
Corp. High Yield EU
5.2
1980 – 2015
5.8
5.4
1998 – 2015
8.6
8.2
8.0
Corp. High Yield US
-1
0
1
2
3
4
5
6
7
8
9
1980 – 2015
10
Alternative
Private Equity
Private Equity Real Estate
0
2
4
6
8
17.2
13
13
7.9
8
8
2004 – 2015
1986 – 2015
10
12
14
16
18
20
History
With innovation shock
Without innovation shock
Page 8
Source: Pictet WM – AA&MR, Datastream
Horizon – Autumn 2015
SINCE 2000, THE US EQUITY MARKET LAGGED, AS IT SUFFERED TWO MAJOR CRASHES
2000 = 100
300
S&P 500 TR (1970)
US BENCHMARK 10 YEAR DS GOVT. INDEX
The BofA Merrill Lynch US Corporate Index - Total Rtn Idx Val
250
The BofA Merrill Lynch US High Yield Index - Total Rtn Idx Val
200
150
100
50
2000
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
Source: Pictet WM – AA&MR, Datastream
30 years was that long-term interest rates were
steadily falling, to a low of 1.4% in the US in
July 2012. As the bond price moves in an
inverse relationship to the yield, US Treasuries
consistently delivered double-digit returns.
With inflation low, this was the case even in
phases of strong economic expansion.
Generating higher returns will mean
accepting higher risk
The question now, as long-term interest rates
normalise, will be how to continue to generate
comparable returns.The only solution will be
to take on more leverage. For example, whereas
in a traditional 60/40 portfolio, 90% of volatility
comes from the equity holdings, a risk parity
portfolio levers the bond holding, and so diversifies the volatility.
However, that means accepting higher risk—
especially if there is a shock to long-term interest
rates. During the ‘taper tantrum’ in July 2013,
when markets panicked over signs from the Fed
that it was ready to start winding down quantitative easing, risk parity portfolios suffered
heavy losses. Our baseline scenario of a radical
innovation shock would help the situation by
substantially boosting returns on equities. Otherwise, in a situation where there is no ‘free lunch’,
investors who are unwilling to accept lower
expected returns will have to decide how much
risk they are prepared to tolerate.
Page 9
“In a situation where there is
no ‘free lunch’, investors who
are unwilling to accept lower
expected returns will have to
decide how much risk they
are prepared to tolerate.”
II. Innovation, growth and
investment
There are concerns that developed economies
may be facing secular stagnation. According
to this theory, structural headwinds to growth,
most notably adverse demographics, could
result in permanently lower trend rates of
economic growth. However, we are more
optimistic. In our view, growth will gradually
normalise as cyclical weaknesses abate, and
there is potential for a radical innovation
shock to boost productivity and hence
economic growth. There is evidence to suggest
that such a shock may be set to emerge.
The spectre of secular stagnation haunts
developed economies
The former US Treasury Secretary Larry Summers
has propagated the idea of secular stagnation to
capture the state of the US economy following
the financial and economic crisis of 2008-09—
reviving a concept originally proposed by the US
economist Alvin Hansen in 1938, in the aftermath
of the Great Depression. Summers argues that
as a result of structural constraints, potential
economic growth has fallen to permanently
lower levels. He focuses on the US, but in fact
the threat of secular stagnation would appear
to be even greater for the eurozone, as well as
an ongoing problem for Japan.
The definition of secular stagnation is not fully
agreed, but, as outlined by Summers, it describes
a persistent tendency for aggregate supply to
exceed aggregate demand. Interest rates are
unable to equilibrate aggregate demand and
aggregate supply, as the neutral real interest rate
is negative, and below the lowest achievable
value for the actual short-term risk-free real
interest rate.
We agree that structural headwinds to growth
have emerged for developed economies, for a
number of reasons, most notably:
• Demography. Demographic trends are
now less supportive of economic growth,
as populations age and the expansion
of the working-age population slows or
even reverses. For example the European
Commission projects a 2.1% fall in the EU’s
working-age population from 2013 to 2020.1
• Education. The education revolution in
western economies implied by the expansion
first of universal schooling and then of mass
higher education is complete, so no further
substantial increase in average in these regions
education levels is likely.This has negative
implications for productivity growth.
• Indebtedness. We have previously
highlighted the trend of the Great Divergence,
where public debt is on an upwards trajectory
but economic growth is on a downhill
path2. Many developed economies are now
struggling with this problem—public debt as
a ratio to GDP has reached 92% in the euro
area, 101% in the US and 224% in Japan.
1
European Commission (2014), The 2015 Ageing Report
2
Donay, C (2012): The New Paradigm of Indebtedness, Perspectives Special Edition, Pictet & Cie
Page 10
Horizon – Autumn 2015
US: DRAWN-OUT RECOVERY (HOUSING STARTS AND PERMITS AS A % OF TOTAL STOCK OF HOUSES)
%
1.9
1.7
Average
1980-2008
1.5
1.3
1.1
0.9
0.7
0.5
0.3
1980
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
12
14
16
Source: Pictet WM – AA&MR, Datastream
Innovation can boost economic growth
However, we are not convinced that the
developed world faces secular stagnation.
First, the concept underplays the influence of
cyclical factors that have weighed on growth
in the aftermath of the crash of 2008-09—
including the weakness of the credit cycle,
the downturn in the US housing market, and
consumer deleveraging. Given the magnitude
of the last boom-bust cycle, recovery has
proven drawn out—the US housing market for
example is reviving only slowly. Nevertheless,
as these cyclical constraints abate, economic
growth will strengthen. For this reason, our
secondary scenario is for a gradual normalisation
of economic growth and inflation, albeit to
moderate rather than strong levels.
Second, the idea of secular stagnation places
too much stress on the impact of demandside problems in holding back growth—its
main proponents, such as Paul Krugman,
favour the Keynesian approach that growth is
driven by demand. We think, by contrast, that
for developed economies, supply precedes
demand—and expanding supply will increasingly
depend on technological innovation.Think
for example of the way in which the advent
of mobile communications technology, driven
by innovation, created demand for mobile
telephones—and subsequently for associated
applications. An innovation shock could boost
productivity growth—which has slowed in the
past decade—and hence overcome structural
headwinds to drive stronger economic growth.
This underlies our baseline scenario for expected
returns. Moreover, we think that a radical
innovation shock may be set to emerge. A radical
innovation shock is one that spreads throughout
the economy and delivers a lasting boost to
economic growth—in contrast to a transient
innovation shock that just benefits a particular
sector or has only a short-lived economic
stimulus (for example, whenever a new iPhone
is launched US retail sales jump temporarily, but
there is not a sustained benefit for economic
growth).
A radical innovation shock may be
in the offing
Genuine technological revolutions take time to
feed through to deliver tangible and sustainable
benefits to economic growth. But signs of such
a revolution are mounting. We have identified
seven key sectors with the potential to play
a leading role in the next wave of radical
innovation: the internet, IT/information and dataprocessing, automation, transport, energy, life
sciences and smart materials. In particular, Silicon
Valley in the US has brought together a critical
mass of technological know-how, innovative
instincts, entrepreneurial energy, and ample
financing that is creating a self-reinforcing wave
of transformative innovation.
Another reason for encouragement is that at
present, with corporates holding large cash
reserves, the private sector is well positioned
to make the sustained investment needed to
support a radical, rather than merely transient,
innovation shock.
Page 11
“The idea of secular stagnation
places too much stress on
the impact of demand-side
problems in holding back
growth. We think, by contrast,
that for developed economies,
supply precedes demand.”
“Radical innovation shocks
deliver a long-lasting boost to
economic growth, as supply
creates demand.”
Radical innovation shocks deliver a long-lasting
boost to economic growth, as supply creates
demand. For instance, in the 1990s the advent
of new computing and communications
technologies propelled US real GDP growth to
3.5%, well above the country’s 2.5% long-term
equilibrium growth rate.
innovation shock is imminent,
then we may already be close
to the end of the early cycle
phase and poised to enter the
acceleration phase.”
• Early cycle phase. The forces that will
unleash a radical innovation shock are
gathering, with investment supporting R&D
and initial commercial application in specific
sectors. A stock-picking approach is best-suited
to this stage, as innovators pursue stock-market
listings and early adopters start to reap the
benefits of the innovation. Silicon Valley’s
tech firms are already collectively worth
over USD3trn (although many tech firms are
relying more on ‘angel investors’ and venture
capital financing for the early stages of their
development than was the case in the
dotcom boom).
• Acceleration phase. As take-up of the
innovation accelerates, the shock spreads
throughout the economy, bringing a
transformative impact across sectors and
• Mature phase. The pace of adoption slows
as the diffusion of the innovation reaches
maturity, and economic growth levels off.
Stock-market indices will be in the excess
phase and are liable to crash or at least correct.
A switch to more defensive strategies is called
for.This may involve a return to a stock-picking
approach, but moving from equities that are
sensitive to the innovation cycle to value stocks.
If we are correct that a radical innovation shock
is imminent, then, judging from the number of
innovative tech companies that have already
emerged and their high valuations, we may
already be close to the end of the early cycle
phase and poised to enter the acceleration phase.
The idea of secular stagnation, therefore, ignores
the potential for a radical innovation shock
to boost supply and hence demand. Factoring
in the possibility of an innovation shock has
considerable implications for expected returns
from asset classes.
THE S-CURVE OF INNOVATION AND INVESTMENT IN INNOVATION
DIFFUSION OF THE INNOVATION AND ECONOMIC GROWTH
“If we are correct that a radical
Investment strategies should evolve along
the S-curve
How can investors profit from a radical
innovation shock? The cycle of such a shock can
be thought of as an S-curve:
pushing economic growth onto a higher
plane. Investment in targeted companies can
continue, but many ‘early birds’ will fail at this
stage. Broader investment in tech-exposed
stock-market indices can also prove rewarding,
as rising economic growth drives up share
prices across the board.
Genesis and early life of the
innovation
Accelerated diffusion
of the innovation
Maturity of the
innovation
INVESTMENT
• Bottom-up approach
• Stock-picking among early birds
WE MAY
BE HERE
Example: 1990-95
INVESTMENT
INVESTMENT
• End of top-down process
• Correction of indices (crash)
• Stock-picking favours defensive
and value stocks
• Top-down approach
• Selection of stock-market indices
benefitting from the innovation
• Darwinian selection of survivors
(bottom-up)
• Excess phase in indices
(bull market)
Example: 1996-2000
Example: 2001-03
TIME
Source: Pictet WM – AA&MR
Page 12
Horizon – Autumn 2015
SEVEN SOURCES FOR A NEW RADICAL INNOVATION SHOCK
Technology sectors
Potential radical innovations
1. Internet
– Mobile apps
– Internet of Things
– Crowd-sourcing, Crowd-funding, Crowd-teaching
2. IT/Information & data processing
– Extension of Moore’s law (new-generation microprocessors)
– Quantum computing
– Big Data
3. Automation
– Advanced robotics – automation of manual labour and expertise (artificial intelligence),
human/machine interface, drones, decision-making processes
4. Transport
– Driverless vehicles
– Vehicles powered by new energies
5. Energy
– Shale oil and gas
– Storage and management of electric power
– New energies – solar, biomass, wind, geothermal, waves/tidal, hydrogen
6. Life sciences
– Pharmaceuticals
– Biotechnology – biomarkers, nanobiotechnology, targeted biologic therapies, genomics (DNA decoding),
molecular and cellular genetics
– Neurobiology (and Neuroinformatics)
– Bioinformatics
– Immunology
– Oncology
7. Smart materials
– Nanotechnologies
– Graphene
– Composite materials
– Use of soft matter/ materials (polymers, proteins)
III.The Internet of Things:
from hype to investment
reality
The evolution of the Internet of Things provides
a clear example of the way that trends in
innovation and technology are rapidly
coalescing to create a potentially revolutionary
impact. The past year or so has seen the idea
of the IoT reach an unstoppable momentum,
to the point where it is widely seen as a huge
industrial and investment theme for the
coming years.While this is undoubtedly true, it
is worth taking a step back to assess what the
IoT really means in the context of investment.
Christopher Seilern
Financial Analyst Technology
The IoT is hardly new. Not only is the Internet
itself now quite old (TCP/IP protocol was first
used more than 30 years ago in 1982), but the
term Internet of Things was coined in 1999 in a
presentation on RFID technology at Procter &
Gamble. Bill Joy, founder of Sun Microsystems,
also talked about it in 1999 at the World
Economic Forum in his 6 Webs presentation.
So why did it take almost two decades to go
from idea to hype? Will it progress from hype
to actual products and services? And will those
create economic value? In a nutshell, yes, and the
reason why this is happening now, as opposed to
five years ago, or five years from now, is based on
three simple factors: cost, ubiquity, and
energy efficiency.
Cost, ubiquity and energy efficiency drive
the IoT’s emergence
Whereas the Internet currently reaches close
to 3 billion people, or 40% of the world’s
population, the IoT is expected to comprise,
according to Gartner Group, over 25 billion
devices, more than three times larger than the
global population. At that scale, cost is the key
determinant, as it is impossible to assume that
Source: Pictet WM – AA&MR, Datastream
Alarm Clock:
Remote programs,
custom tones,
turns on coffee maker
Electric Toothbrush:
Automatically reorders
brush heads, shares brushing
habits with your dentist
Refrigerator:
RFID1 tags reorders
groceries as needed,
and suggests recipes
Automobile:
Maps traffic in real
time; others can
track your location
Home/Bed
Workplace
Coffee Maker:
Custom setting for
each coffee type,
starts when alarm
goes off
Page 14
Smart Scale:
Measures and
sends weight info
progress tracking
Oven: Oven
settings from
computer or phone
if running late
Cell Phone:
Secure performs
identification and
verification for
payments
Horizon – Autumn 2015
the next 20 billion devices will cost thousands
of dollars each. For the IoT to make economic
sense, the majority of connected devices will
have to cost tens of dollars or less.
The second determinant, ubiquity, is also starting
to become a reality, through the economics
of connectivity. Both wired and wireless
connectivity have been around for decades. But
the availability of extremely low cost wireless
connectivity is a relatively new phenomenon:
a GSM module can now be bought for less
than $10, Wifi for less than $3 and Bluetooth
for less than $1. At these cost levels, the kind of
devices that can be economically connected to
the Internet increases exponentially. As a result,
the last year or so has seen an avalanche of
Internet-connected products that would have
not been viable only a couple of years earlier:
lightbulbs (Philips), thermostats (Google), garage
door openers (Chamberlain), clothes washers
(Whirlpool), cooking pots (Belkin), or weighing
scales (Fitbit) among myriad others.
The last factor, energy efficiency, is also crucial.
At 0.80kWh per day, a desktop computer’s
electricity consumption is less than 2% of
the average American’s daily electricity usage.
But 0.80kWh is 10% of the average Chinese
citizens’ daily electricity usage. Clearly, energy
efficiency is key, and ultra-low energy use is an
absolute requirement for IoT devices, especially
in emerging markets or away from traditional
electric grid access. For example, whereas
Bluetooth is a wireless standard that has existed
for more than a decade, Bluetooth Low Energy
only began to be used in 2011.
The alignment of cost, ubiquity and energy
efficiency has allowed mass market applications
to be developed in virtually every field
of industry.There are now IoT products
and services in environmental monitoring,
infrastructure management, industrial
automation, energy management, medical
systems, transport systems and building/home
automation, among others.
Home automation and monitoring is
well advanced
Rather than attempt to address all of these
verticals, let us focus on the home, where aspects
of the standardisation process and product and
services availability are the most advanced. Home
automation and monitoring has seen some of
“Home automation and
monitoring has seen some of
the most innovative IoT devices
so far, and some of the world’s
largest tech companies have
finally begun to address this
market opportunity.”
Printer:
Automatically
reorders toner and
paper as needed
Computer:
Centralised control for
remote interface
to any other device
VoIP phone:
Automatic updates,
integration
and forwarding
2
Media Player:
Remotely orders
new songs and video
Microwave:
Automatically sets
cook cycle with
RFID1 recognition
Home/Bed
HVAC3: Controls
temperature &
lights for maximum
efficiency
1
Radio Frequency Identification
Building Security:
Security cameras
interact with facial
recognition database
Vending:
Automatically
reorders supplies
before it is empty
2
Voice over Internet Protocol
3
Heating Ventilation Air conditioning
Exercise Equipment:
Recognizes individual
user and tracks
workout schedule
Television:
immediate "one-click"
ordering of products
seen on commercials
Source: Pictet WM – AA&MR
Page 15
the most innovative IoT devices so far, and, more
importantly, some of the world’s largest tech
companies have finally begun to address this
market opportunity.This matters because the
home is one of the broadest, most visible and
most standardised IoT market opportunities.
“Clearly, Google, Apple and
Cisco will likely be central
players in an IoT future. In
addition, more companies
will emerge and develop
standardised IoT products and
services.”
Whereas it is already a few years since Cisco
refocused its products and services around an
IoT future, it was only recently that both Google
and Apple began addressing this opportunity
in a big way. Google spent almost USD4 billion
acquiring Nest (a maker of thermostats and
smoke detectors) and Dropcam (a maker of
webcams), and has also opened up its Home
automation ecosystem to third parties. Mercedes
Benz and Whirlpool have been among the first
to develop connected products compatible
with Google’s home automation products and
services, and many others will follow.
Apple too has begun treading in Internetconnected home automation. iOS 8 (iPhone,
iPad, iPod and AppleTV) now includes Homekit,
an Apple standard designed to federate
communications between disparate connected
devices in a user’s home (think TV
to toothbrush).
companies from the PC era whose business focus
is on one specialised vertical (semiconductors
or PCs for example), or whose products preclude
networks effects (software or services
for example).
From an investment standpoint, now is
the time when the winners and losers in a
hyperconnected IoT world are starting to
emerge. Much like the industrial revolution, or
the jet age, this new revolution will likely see
create companies larger than ever before, with
global footprints, that drive economic value in
virtually all parts of the economy.
At first glance, both Google’s and Apple’s
approaches might seem quite technical and
devoid of substance, as only a handful of
compatible devices exist today. However, as
so often in the past, the key is platforms and
standards. Few platforms in any industry can
compare to Apple’s 800 million iTunes accounts,
or the more than 1 billion people using Google’s
products and services. Furthermore, it is also
quite likely that Google and Apple, as the de facto
leaders in the world’s most connected industry,
the mobile phone market, will dominate and
determine IoT standards as a whole.
Winners and losers are starting to emerge
Clearly, Google, Apple and Cisco will likely be
central players in an IoT future, even if the
direct upside to their share prices remains
difficult to quantify at this point. In addition,
more companies, such as Ubiquity Networks or
Sonos, will emerge and develop standardised IoT
products and services.
On the flip side of this wall of innovation and
growth will be companies that may have great
products and businesses, but will suffer from
their inability to set standards and retain pricing
power in a world dominated by a handful of
platforms with billions of users.This means
Page 16
Horizon – Autumn 2015
Page 17
IV. Working framework for
calculating expected returns
When carrying out wealth planning and
the associated strategic asset allocation, it is
necessary to calculate the expected long-term
returns of the various asset classes. Academic
research strives to differentiate the risk factors
that drive returns, but a comprehensive
theoretical structure has yet to emerge. At Pictet,
we have developed a proprietary risk factorbased approach in order to calculate 10-year
expected returns of asset classes.1
“We have identified two
essential risk factors to assess
the long-term returns of asset
Economic growth and inflation are key
Of the three methods most commonly
encountered for calculating ten-year returns—
reversion to the mean, forecasting using
confidence intervals, and the risk factor
approach—we find the risk factor approach to
be the most suitable. Notably, it allows for the
incorporation of innovation shocks.
We have identified two essential risk factors to
assess the long-term returns of asset classes: the
real economic growth regime and the inflation
regime.These two risk factors have a strong
correlation with all the main asset classes. Under
our risk factor approach, therefore, the expected
returns of asset classes depend on scenarios for
real economic growth and inflation, alongside a
hypothesis on the likelihood of a shock to the
economy.Asset-specific factors will also play a role.
classes: the real economic
growth regime and the
In order to simplify the vast range of possibilities
for real economic growth and inflation, we
determine three principle economic growth
regimes (standard, low and strong) and three
main inflation regimes (standard, low and high).
These intersect to give nine possible economic
regimes—although only seven of those are
realistic in practice.
inflation regime. They have a
strong correlation with all the
main asset classes.”
ECONOMIC REGIME GRID
Weak growth
gr =1%
Standard growth
gr = 2.5%
Strong growth (Innovation shock)
gr = 4%
Low inflation/deflation
π = 0.5%
Deflationary climate
Europe, 2010s
Unlikely
Unlikely
Standard inflation
π = 2%
‘The New Normal’
US, 2000s
‘Goldilocks’
US, 1990s
‘The Golden Age’
US, 1980s
High inflation
Stagflation
Inflationary climate
Overheating climate
π = 4%
US, 1970s
Emerging economies, 1970s
China, 2000s
Source: Pictet WM – AA&MR
1
For further details, see Pictet & Cie (2015), Calculation methodology for 10-year
expected returns from asset classes.
Page 18
Horizon – Autumn 2015
US: REAL GDP GROWTH (ANNUAL Y-O-Y CHANGE)
%
8
%
High inflation
Great Moderation
Great
Deleveraging
Great Demonetisation
6
4
2
0
-2
-4
1960 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18
Source: Pictet WM – AA&MR, Datastream
Innovation shock or return to the norm?
Starting and end-point regimes could be different.
It is vital to take account of the possibility of a
shock to the economy leading to a change of
economic regime: all recent decades have closed
with growth and inflation regimes different
from those that began the decade.We therefore
have two main scenarios: with and without an
innovation shock.A radical innovation shock could
be a technology shock (which we view as most
likely at present), a social shock, or a policy shock.
are feeding through into consumption. US
real economic growth has exceeded 2% y-o-y
for the past three years. Inflation by contrast
remains subdued, hovering around 0.0% y-o-y
in the first half of 2015.
• End-point regime: strong growth and
standard inflation. Under the impact of an
innovation shock, US trend economic growth
would accelerate to around 4%. Inflation
would remain under control, at around 2%,
with the Fed likely to adopt a cautious stance.
In our baseline scenario, an innovation shock
over the next ten years (which we assume for the
basis of our calculations occurs in 2017) results
in a change of economic regime over the forecast
period. Economies would initially continue
to evolve according to their current regimes.
Following the innovation shock, the full impact
on growth and inflation would not emerge until
the later part of the decade. Economies would
function fully under the new regimes from 2020
onwards.
Europe:
In our secondary scenario, without an innovation
shock, growth gradually returns to its long-term
potential.This scenario is very close to reversion to
the mean.
• End-point regime: strong growth and
standard inflation. Even if, as seems most
likely, a radical innovation shock originated
in the US, Europe would also participate.
Following in the US slipstream, economic
growth would accelerate to around 3.5%
(lower than the US owing to greater obstacles
to the diffusion of new technology and to
productivity improvements in Europe). As with
its US counterpart, the ECB would be likely to
adopt a fairly hawkish position on inflation,
containing it at close to 2%.
Baseline scenario: Innovation shock
United States:
• Starting-point regime: standard growth
and low inflation. The normalisation
process we expected for the US economy has
materialised through concomitant upturns in
the housing market, lending, and jobs, which
• Starting-point regime: weak growth and
low inflation. Real economic growth in the
euro area has been averaging barely 1.5% in
the past three years, and there were fears of
deflation taking hold before the ECB launched
its QE programme in 2015. Many European
economies are also struggling with what we
call the ‘Great Divergence’, where public debt
is on an upwards trajectory but economic
growth is on a downwards path.
Page 19
“It is vital to take account of
the possibility of a shock to the
economy leading to a change
of economic regime.”
Asia ex-Japan:
Europe:
• Starting-point regime: strong growth
and standard inflation. Economic growth
in emerging Asian economies has slowed in
recent years. Most notably, China’s growth
has fallen from 13% on average over the past
15 years to 7% at present. However, it is still
well above levels in developed economies,
and typically above what we would consider a
standard growth regime for emerging markets.
Inflation has been broadly contained in most
major emerging Asian economies.
• End-point regime: standard growth
and standard inflation. Our secondary
scenario foresees a gradual normalisation of
economic growth in Europe, with real GDP
growth increasing to around 2% and inflation
stabilising at around 2%.
• End-point regime: strong growth
and standard inflation. Emerging Asian
economies would also benefit from an
innovation shock, both from higher demand
in the US and Europe and from technology
spillovers that would raise productivity.
Economic growth, rather than continuing to
slow, would stabilise at around 7%. Inflation
would remain in a standard regime.
Secondary scenario: No innovation
shock
Asia ex-Japan:
• End-point regime: standard growth and
standard inflation. Economic growth in
emerging Asia will continue to slow. China
faces an adjustment phase, with reliance on
extremely high investment growth no longer
sustainable—growth will slow to below 6% by
the end of this decade and further thereafter.
Growth for other emerging Asian countries
will also decrease as their economies mature.
There are upside risks to inflation, notably in
China, from rising labour costs, but weakening
demand pressures should result in inflation
remaining in a standard regime (for emerging
markets) of around 4%.
United States:
• End-point regime: standard growth and
standard inflation. Absent an innovation
shock, US trend economic growth is likely to
stabilise at around 2.5%.
Page 20
Horizon – Autumn 2015
BACKGROUND TO THE DECADE
THE ECONOMIC SHOCK
After the end of the Yom Kippur War in
1973 between Israel and a coalition of
Arab states led by Egypt and Syria,
OPEC forced the price of crude oil
upwards. The price per barrel trebled
from 3 to 10 dollars in the space of
less than three months.
OPEC’s manoeuvring triggered an oil crisis,
giving rise to an economic phenomenon
never before encountered in the developed
world: stagflation, a toxic cocktail of
pedestrian growth and annual inflation
racing along at 12%.
1970
Ronald Reagan’s election as US
President in 1981 led to new fiscal
policies being instigated involving a
whole raft of tax cuts and implementation of very restrictive monetarist
policies geared to bringing inflation
down.
Ronald Reagan’s supply-side economics,
dubbed ‘Reaganomics’, coupled with Fed
Chairman Paul Volcker’s strict inflation
targeting, served to energise the US
economy to average annual growth of 3.5%
and to lower inflation to close to 2% by the
end of the decade. This sent US equities
and, by transatlantic transmission,
European shares on bull runs.
1980
The invention of the Internet in 1990
brought about a blossoming of myriad
new technologies during the decade that
followed, making innovation and
investment the twin dynamos driving
economic growth.
Boosted by investment and consumer
spending associated with the new
technologies, real GDP growth in the US and
Europe sustained a robust tempo, averaging
rates of over 3% and 2%, respectively.
Inflation-targeted monetary policy helped to
keep the trend on price increases steady at
around 2%.
1990
The bursting of the dotcom bubble in
2000, followed by the terrorist attacks
on 11 September 2001 in New York and
the sub-prime crisis in 2007-08,
brought a period of low volatility in
economic variables (like inflation or
real GDP growth) to an end.
Two major shocks, in effect, occurred during
the decade. These were: (1) the bursting of
the US housing bubble, with the ensuing
collapse of Lehman Brothers investment
bank in September 2008 triggering a global
financial crisis; and (2) the sovereign debt
crisis in the euro zone, with peripheral
European states requiring bailouts and
the integrity of the euro zone called
into question.
2000
The global economic recovery from the
deep recession of 2008-09 has proven
drawn out, and the euro zone has been
held back by a sovereign debt crisis.
However, by the midpoint of the decade,
US economic growth looked increasingly
robust, and the euro area appeared to
be over the worst.
A radical innovation shock in the second
half of the decade appears most likely to
come from technology. We have identified
seven key sectors with the potential to play
a leading role in the next wave of radical
innovation: the internet, IT/information and
data-processing, automation, transport,
energy, life sciences and smart materials.
2010
*Average annualised nominal return over 10 years (projected for the 2015-25 period),
in local currencies, with dividends and coupons reinvested
ASSET OF THE DECADE
US cash
6.3%
*
This high return on US cash
resulted from the spike in interest
rates as they soared from 5% at
the outset of the 1970s to 14% by
the start of the 1980s.
European equities
22.7%
*
Steadily declining interest rates
fed through into unprecedentedly
impressive returns from shares.
US equities
18.2%
*
Bull markets on Wall Street and
in Europe reflected market
expectations of very strong
corporate earnings growth.
10-year German Bunds
10.3%
*
Quantitative easing and
non-conventional monetary
policies prompted a sustained
rise in prices of sovereign
bonds.
Developed-mkt. equities
10.2%
*
Developed market equities
appear the most attractive
asset, given a more favourable
balance of risk and reward than
in emerging markets.
Page 21
Authors: Christophe Donay
Editorial team: Aidan Manktelow, Kalina Moore, Wilhelm Sissener
Design and editing consultants: Production Multimedia Pictet
Translation: Pictet Language Services
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Furthermore, the information, opinions and estimates in this document reflect an evaluation as of the date of initial
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