Tackling traditional assets’ low future returns

Key takeaways

• As inflation rises and monetary policy progressively normalises, the economic and financial landscape in the next decade is set to look very different from what it has been over the past 30 years.
• Higher structural inflation may chip away at real returns for investors and challenge long-standing principles of portfolio management.
• While blue chip equities will continue to play a key role in portfolios, other assets such as high yield and EM corporate debt, ‘innovation-related’ stocks and convertibles could all help boost portfolio returns.
  

A new regime for traditional assets

Traditional asset classes, i.e. stocks and bonds, are fast approaching the end of a long cycle that saw them deliver very solid returns over several decades. While long-term developed market (DM) nominal bond yields declined steadily from their peak in the early 1980s until the pandemic outbreak in March 2020, significant capital gains compensated for the gradual erosion of government bond coupons. On top of providing protection to portfolios, government bonds thus offered an attractive risk/return profile. Stocks, meanwhile, enjoyed a combination of positive factors, from mostly resilient economic growth to loose financial conditions.

But the next 10 years are set to look different. The sharp acceleration in inflation since 2021 may draw a line under years of ultra-accommodative monetary policy, with significant consequences for bonds and equities alike.

Equity prices can typically be broken down into earnings and the valuation multiples applied to them. Over the long run, however, equities are largely driven by the former as valuations tend to revert to mean. Earnings mainly depend on revenues (which closely track nominal GDP growth) and margins. At time of writing (March 2022), both margins and valuations were looking stretched, especially as financial conditions have begun to tighten and visibility on future economic growth has deteriorated. With this in mind, we expect DM equities to make an average annual nominal return of 6.0% over the next 10 years, roughly half the level of the past decade.

As central banks engage in a relatively steep rate-hiking cycle, there should be a mechanical improvement in nominal returns from cash. The Japanese yen aside, major DM currencies should deliver a nominal return of 1-2% in local terms in the next 10 years (1.9% for the US dollar and 1.2% for the euro).

While higher yields (linked in part to higher policy rates) support sovereign bond returns in the long term, they also induce a fall in bond prices, eroding our return forecasts compared to cash. We expect 10-year US Treasuries to deliver an annual average total return of only 1.7% in nominal terms (much lower than the 7.5% per annum recorded from 1980 to 2021), but still offer better returns than their German and Japanese counterparts (0% and -0.1%, respectively). Thanks to higher sovereign yields and recent widening in spreads, DM corporate bond yields have risen recently, enabling us to raise our annual forecasts to 3.2% for global investment-grade (IG) and 3.9% for high-yield (HY) over the next 10 years.

Risk of return erosion due to higher inflation

A key feature of this year’s edition of Horizon is our belief that we may be witnessing a regime shift towards higher structural inflation. In such an environment, investors should increasingly consider real rather than nominal returns.

Absent strong growth, high inflation chips away at asset performance, hence pushing investors towards higher-risk instruments to achieve their inflation-adjusted (i.e. real) return objectives. Indeed, based on our projections, most cash and DM sovereign bonds will yield negative real returns in the coming decade, while we project DM equities to return only 3.0% on average per year in real terms.

Our central belief is that central banks will rediscover their inflation-fighting vocation and raise policy rates accordingly, partially offsetting the negative impact of rising prices on investors. However, the significant stock of debt that has been built up in the global financial system since the financial crisis of 2008-2009 constrains monetary policies and may lead to financial repression (i.e. an environment where real returns from cash and sovereign bonds are negative).

Higher structural inflation may also challenge traditional portfolio construction as the correlation between stocks and bonds tends to turn positive during inflationary times. In other words, in a regime of structurally higher inflation, sovereign bonds may not be as effective a hedge for portfolios as they used to be.

How to boost real returns?

In this context, equities will still play a key role in any asset allocation that aims to generate real positive returns. Some structural themes may provide a boost to equity performance (for instance, playing innovation through the Nasdaq 100 may add two percentage points over the S&P500), and the most daring investors may want to take advantage of currently low valuations to invest in emerging market (EM) equities (for which we project a real return of 4.1% p.a. in USD terms). Our expectation of a real average return of 4.6% per annum for Chinese equities is a case in point.

While government bonds’ role as an effective hedge may be brought into question to some degree and while their real return prospects look negative, bonds’ carry should become increasingly attractive as yields rise. Taking additional risk will be necessary to prop up fixed-income returns—for instance, by investing in EM corporate debt (for which we expect an average annual real return of 1.5% in USD over the next 10 years) or DM HY corporate bonds (0.9% in USD).

Hybrid instruments could also boost long-term returns. Convertible bonds, for instance, exhibit equity-like characteristics when the underlying share price rises, while at the same time they provide some downside protection. We expect US convertibles to provide an average real return of 1.9% per year over the next 10 years.