Investors need to look further afield to generate asset returns – both geographically and beyond public markets.
- Almost two years after the pandemic struck, the global economic recovery has strong momentum, kicked off by huge fiscal and monetary stimulus and now sustained by a robust capex cycle and solid household balance sheets. The economy has suffered limited scarring, but policy choices have an enduring impact. In any case, our message is optimistic: Despite low return expectations in public markets, we see plentiful opportunities for investors.
- Our nominal growth forecasts rise a little this year in developed markets, and we anticipate more two-sided risks to inflation. While a sustained rise in inflation does pose a risk, it is neither the only plausible outcome, nor is it an imminent endgame to the dislocations apparent in the current cycle.
- We expect policy rates to rise slowly, lagging nominal growth and leaving returns for cash and most developed market government bonds negative in real terms. Bonds are serial losers in many states of the world, and bondholders not only face a deprivation of coupon income but also suffer under financial repression. In fixed income, credit remains our preferred asset.
- Equity returns are stable, even after a year of strong returns since our last publication. Adjusting for today’s sector mix implies better margins and more supported valuations than history alone suggests. Nevertheless, the best performance is still to be found in alternative assets, where solid alpha trends and the ability to harvest illiquidity risk premia support returns relative to public asset markets. Comparatively, real assets in particular may emerge as serial winners in a wide range of economic scenarios.
- Returns are constrained. But for investors willing to expand opportunity sets, harness novel sources of risk premia and employ some degree of active investment decision-making, there are sources of alpha and the capacity to generate robust and efficient portfolios.
INTRODUCING THE 2022 LONG-TERM CAPITAL MARKET ASSUMPTIONS
Our 2022 Long-Term Capital Market Assumptions (LTCMAs) represent the 26th edition of our 10- to 15-year risk and return forecasts. We anticipate slightly stronger nominal growth in developed markets, on average, across our investment horizon. After a tumultuous two years navigating a global pandemic, that was hardly a given. But the global economy has accelerated rapidly away from a coronavirus-induced slump, helped at first by overwhelming policy support and later by a surge in capital spending and the unleashing of pent-up consumer demand. Today, we are at – or at least close to – escape velocity,1 with the potential growth of the global economy mercifully undiminished by the experience of COVID-19.
The policy interventions at the height of the crisis have a long-lasting impact. In the short run, they create a strong, if distorted, cycle, with solid support for risk assets. In the longer run, those distortions must eventually be resolved, but the mechanism by which this happens is, in our view, neither imminent nor fully clear. To be sure, expected returns remain low by historical standards. A 60/40 portfolio2 will return just 4.30%, we project. But the good news is, investors can find ample risk premia to harvest if they are prepared to look beyond traditional asset markets and past the familiar market risk-return trade-off.
ECONOMIC SCARS FROM THE PANDEMIC ARE QUICKLY FADING
This year, we revise up our nominal growth forecasts 10 basis points (bps) for developed markets, to 3.30%, comprising a real GDP forecast of 1.50% and an inflation assumption of 1.80% (EXHIBIT 1A). We are increasingly convinced that the pandemic will leave behind relatively few economic scars. Less than one year ago – in the depths of the pandemic – forecasters were grappling with the risk that COVID-19 would leave in its wake high and lingering unemployment, widespread bankruptcies and a lasting erosion in the willingness of households and businesses to spend.
Greater investment could spur upside to productivity over the coming cycle compared with the last one
EXHIBIT 1A: PRODUCTIVITY IN DEVELOPED MARKETS: 25 YRS, LAST 10 YRS AND LTCMA 2022 FORECAST
The pandemic may not be over, but we see little evidence of such economic damage. The recovery in business investment and continued improvement in labor productivity suggest the underlying dynamics of real economic growth are reassuringly robust.
Critically, our estimate of potential growth is little changed compared with pre-pandemic levels (EXHIBIT 1B). This is noteworthy because over the last four quarters we’ve seen an extraordinary cyclical recovery and strong returns from risk assets. Despite banking these outsize growth and returns, our long-term growth forecasts remain relatively stable compared with last year, implying that, allowing for cyclical factors, there is a solid underlying growth trend.
Our estimates for nominal growth are slightly better in developed economies and slightly lower in emerging economies; the overall trend remains stable
EXHIBIT 1B: NOMINAL GROWTH RELATIVELY STABLE COMPARED WITH PRE-PANDEMIC
This year, our nominal growth expectations get a boost in our LTCMAs in light of the higher inflation that central banks are now targeting. Indeed, after being worried about disinflation for many years, this year we have raised our long-term inflation projections, as risks around central banks’ inflation targets are now more balanced. Modestly higher inflation in turn creates a tailwind for risk assets, even as it spells out a warning for bondholders.
The effect of pandemic policy choices will linger, but in short, we are broadly optimistic. Equally, we must acknowledge that the very same bold fiscal and monetary policy that propelled us out of the pandemic gloom represents a seismic and lasting evolution of economic policy. Gone is a decade of sluggish capex, periodic austerity and weak productivity, offset by loose monetary policy. In its place, we find an emphasis on nominal growth and a greater willingness to tolerate larger balance sheets and higher national debt than we’ve seen since 1945.
But we should be in no doubt that without the swift and wide-reaching action from policymakers we would be left with a dismal economic foundation for our asset projections.
Instead, emboldened by their pandemic policy success, governments are now focused on medium-term ambitions (EXHIBIT 2). Multi-year spending plans have already been laid out with an emphasis on rebuilding crumbling infrastructure, addressing social inequality and tackling climate change.
Investment across developed markets was scarce in the last cycle but so far in this one is surpassing the early 2000s levels
EXHIBIT 2: NOMINAL GOVERNMENT INVESTMENT ACROSS KEY REGIONS (%, AVERAGE ANNUAL GROWTH RATE)
DISLOCATIONS WON’T NECESSARILY CLOSE SWIFTLY
While the lack of economic scarring, strong fiscal stimulus and negative real rates combined to kick-start the economy, they also stoked fears of an inflationary endgame. The prevailing cycle may well be operating in a dislocated state. Continued accommodative policy would seem to be in tension with an outlook for robust growth. Yet this mix could persist for some time. Policymakers seem willing to bear the risk of capital misallocation in the long run in pursuit of nominal growth today.
Longer-term uncertainties do bear scrutiny but equally should not suppress a willingness to deploy capital in what is now a favorable environment for risk assets. The nature and pathway by which dislocations close are not predetermined. In most plausible cases, though, it is bondholders who suffer, real asset owners who tend to win and equity holders who should be nimble and opportunistic. Despite the risks created by the current policy and growth mix (EXHIBIT 3), a pro-risk tilt is probably appropriate for many investors.
Over our 10- to 15-year horizon, we look through some of the cyclical risks and instead home in on risks that might alter trend growth or inflation, or leave a lasting imprint on long-term asset returns
EXHIBIT 3: OUR CORE CASE SEES POSITIVE NOMINAL GROWTH, WITH POLICY REMAINING RELATIVELY EASY FOR SOME TIME, BUT THERE ARE RISKS TO THIS LONG-RUN VIEW
Investors cannot ignore the more interventionist approach by governments. Incorporating environmental, social and governance (ESG) ambitions into investment decisions is increasingly critical. Will this approach hamper financial returns? Our analysis suggests not, as long as investors don’t reduce their opportunity set by focusing solely on assets for which scores are easily available or score highly. Sustainable investing might once have been about “doing good”; it is now as much about “doing well.”
Governments may well look to raise taxes to fund their spending ambitions. Many governments will find that their capacity to raise income taxes is severely limited. Few lawmakers believe their taxpaying public has shoulders big enough to bear the increases, but also, aging populations are shrinking the pool of workers with an income to tax in the first place. Instead, governments are looking more closely at corporate, wealth and capital gains taxes to raise revenues – so investors should take note, given the rapid wealth gains of recent years (see “Tax as an Investment Issue: Weighing the impact of tax loss harvesting on long-term saving goals”). In any case, broad-scale austerity is a thing of the past, and raising revenues becomes a governmental priority.
BONDS LOOKING LIKE SERIAL LOSERS
There is a cost, and it will be borne by bondholders. Our central scenario of respectable post-pandemic nominal growth, and governments with the funds they require for their medium-term ambitions, might seem too good to be true. Have governments discovered a free lunch?
Hardly. The apparent free lunch has been served by the central banks. Their asset purchases insulated governments from the higher interest rates that would surely have ensued were the market left to its own devices.
Central bank support will still be needed as governments pursue their medium-term ambitions. Our process of forecasting bond returns accounts for this reality. Understanding what the macro economy would suggest for the path of bond yields is now only part of the story. Considering what central banks will allow bond yields to do is equally important. Our forecasts also factor in the role of other large non-price sensitive buyers, such as liability hedgers and pension funds.
While the outlook for government bonds remains dire, our forecasts for nominal bond returns improve from 2021. Higher starting yields and simply moving forward one year – such that our calculations drop one year of zero or negative policy rates and include a year of at least modestly higher rates at the end of the forecast horizon – improve bond returns. Together, these factors push our 10-year U.S. Treasury returns forecast 80bps higher, to 2.40%, while USD cash returns forecasts are up by 20bps, to 1.30%. Nevertheless, given our U.S. inflation estimate of 2.30%, this still implies negative real returns for cash and virtually zero real return for Treasuries, on average, across our forecast horizon. Outside the U.S., the picture looks bleak, with nominal government bond returns of just 1.30% for 10-year EUR and 1.70% for 10-year GBP, which imply significantly negative real returns.
In short, government bonds look like the serial losers across our forecast horizon in return terms, even though we acknowledge they may still have a role as diversifiers. An extended period of financial repression in the current cycle acutely hurts bondholders. Should prevailing dislocations close through a burst of inflation, bonds will surely suffer, and should the dislocation close with better productivity, real rates will need to rise. This may offer the promise of a higher coupon eventually, but it could well be many years away (EXHIBIT 4).
Real borrowing costs for U.S. and European corporates and governments are now negative in real terms and likely to remain so for some time
EXHIBIT 4: REAL YIELDS HAVE TRENDED DOWNWARD OVER THE LAST QUARTER CENTURY
Understanding that the bond market will remain highly managed influences how we view expected returns across extended fixed income sectors (EXHIBIT 5). In essence, running an economy hot for an extended period will depress defaults, favoring lower quality fixed income. However, this outcome is already at least partly reflected in tighter spreads. As a result, our U.S. high yield (HY) return forecast drops from 4.80% to 3.90%. Higher starting riskless yields offset tighter spreads in U.S. investment grade (IG), leading to a 30bps improvement in returns, to 2.80%. But again, this needs to be seen in the context of expectations that U.S. inflation will average just 2.30%.
Return forecasts for government bonds rise due to higher starting yields and the fact that we are a year closer to our assumed start of normalization
EXHIBIT 5: PROJECTED CYCLE-NEUTRAL YIELDS AND FIXED INCOME RETURN PROJECTIONS
EQUITY RETURNS STABLE BUT CYCLICAL
Our equity forecasts expand on this thought process. An extended period of negative real rates has altered how we think about equilibrium valuations and margins (EXHIBIT 6A). Mean-reversion assumptions for valuations and margins are commonplace, but these must be viewed in the context of the sector composition and capital structure of indices today. Simply adjusting historical U.S. P/E ratios for today’s sector mix adds 1.5 points to historical average valuations (See Equity Assumptions, Exhibit 2). Accounting for lower corporate capital intensity adds further to equilibrium.
The revealed preference of corporate executives to defend stock valuations is also key. As we explored in “The Evolution of Market Structure: Managing illiquidity risk across public and private markets,”3 the role of equity as an acquisition currency has driven the trend toward higher valuations. This is supported by a shift in how firms tend to use the equity market: 50 years ago, the stock market was where firms raised capital to finance new ventures; today, increasingly, it is where firms return capital to shareholders, in turn underpinning their valuations. Without accounting for the secular shift in index composition and corporate capital structures, the valuation drag would imply exceptionally low, even negative total equity returns over a decade or more, which we believe is neither realistic, nor particularly well supported by historical precedent (EXHIBIT 6B).
Ten-year annualized total returns were 2.3% higher when starting in a negative real rate environment
EXHIBIT 6A: CYCLICAL VS. STRUCTURAL RETURN DRIVERS FOR KEY EQUITY AND OTHER ASSETS
EXHIBIT 6B: 10-YR TOTAL EQUITY RETURNS WERE ONLY NEGATIVE TWICE IN THE LAST 100 YEARS, AND NEVER WHEN STARTING REAL RATES WERE NEGATIVE
Drawing on this more sophisticated approach to projecting valuations and margins, we forecast an unchanged 4.10% annual return for U.S. large cap equities over our investment horizon, while the favorable margin and valuation impact improves our eurozone equity forecast 60bps, to 5.80%.4 We make a small cut of 10bps in Japan, to 5.00%, and a large downward adjustment of 260bps, to 4.10%, for UK stocks, where today’s sector mix points to substantial margin headwinds and likely multiple contraction. Emerging markets see a more modest 20bps dip, to 6.60%. These changes combine to pull our estimate of global equity returns down 10bps, to 5.00% in USD terms.
Once currencies are translated into USD, tailwinds still favor regions outside the U.S. But given the favorable index composition and resilience of earnings, in risk-adjusted terms U.S. equities continue to hold their own. At the margin, the gap between emerging market (EM) and developed market (DM) return forecasts narrows by 20bps in USD terms, driven primarily by our trimming of MSCI China equity return forecasts from 6.60% to 6.30%.
Equities performed strongly early in the post-COVID-19 recovery. Amid easy policy, strong investment spending and elevated savings, we see further upside in stocks. Dislocations apparent in this cycle are more damaging to bondholders than stockholders, and they could endure for some time. To be sure, equity owners may need to be nimble and adjust positioning proactively with the cycle. But longer-term inflation risks are no reason to avoid stocks today.
LOOKING BEYOND PUBLIC MARKETS AND GEOGRAPHIC BORDERS
While much has changed over the past two years, one principle remains very much in force: Investors need to look further afield to generate asset returns – both geographically and beyond public markets. They must also search harder for yield, evaluating and accepting tradeoffs in terms of volatility and illiquidity.
As China’s economy and capital markets mature, investors will increasingly look to the opportunities they present. To identify those opportunities, investors will need to understand Beijing’s long-term strategic ambitions as much as the economics of any investment case – as this past year’s developments have demonstrated (see “Chinese assets: The biggest risk for investors would be to ignore them”). Chinese asset markets are already huge, but the assets are mostly domestically held (EXHIBIT 7). Many investors are structurally underweight China. As a stand-alone investment, bringing Chinese asset exposure up to market weight can enhance portfolio outcomes while allowing for greater balance in emerging market ex-China exposures.
China represents almost a fifth of world GDP and has huge asset markets, but non-Chinese investment is still a small share
EXHIBIT 7: FOREIGN OWNERSHIP OF SELECTED CHINESE ASSETS
Looking beyond public markets is also increasingly essential. As they did last year, our return forecasts (EXHIBIT 8) for alternative assets compare favorably with public market returns. The benefits of alternative assets – improving alpha trends, the ability to harvest risk premia from illiquidity, and the opportunity to select managers that can deliver returns well above what is available from market risk premia alone – will continue to attract capital over the coming decade.
In general, forecast returns for alternatives and private assets have held up well this year
EXHIBIT 8: SELECTED ALTERNATIVE STRATEGIES RETURN ASSUMPTIONS (LEVERED,* NET OF FEES, %)
Financial alternatives offer a marked uplift compared with public markets, with cap-weighted private equity up 30bps from last year, at 8.10%, and private debt offering 6.90%, a favorable uplift when compared with public credit returns. While financial alternatives generally do have an equity beta, the additional returns available from manager selection can deliver a meaningful boost to portfolios.
MISPRICED LIQUIDITY RISK MAKES REAL ASSETS THE SERIAL WINNERS
Real assets continue to stand out as an opportunity set that is both attractively valued – not having participated fully in the post-pandemic risk rally – and also likely to be resilient in multiple future states. In the near term, strong income streams in real estate, infrastructure and transportation assets are welcome when bond yields are compromised. Returns in U.S. core real estate of 5.80% are only 10bps down on last year, while core infrastructure is steady at 6.10% and core transportation just 20bps lower at 7.40%. Returns in all categories are substantially higher than in comparable public credit or equity assets. Above all, real assets offer not only strong income but resilience to inflation and gearing to growth.
Despite liquidity issues in a number of alternative markets, the stability of returns across various future states now seems compelling for asset allocators. Moreover, in our view, investors regularly overestimate the liquidity they might need through the cycle and, as a result, underutilize illiquid assets.
This may be especially true across real assets, where liquidity concerns and the muscle memory of the performance of real estate in the global financial crisis can lead to underallocation. However, in the same way government bonds look to be serial losers in many possible scenarios over our investment horizon, we believe real assets may prove to be serial winners. Strong cash flows, attractive valuations, decent income and gearing to nominal growth should offset concerns about illiquidity for many investors, in our view.
U.S. DOLLAR REMAINS RICH IN MANY CROSSES
We once again see the U.S. dollar as rich compared with most other currencies, with the notable exceptions of the Brazilian real and Mexican peso. Over time, a rich dollar implies that nondollar owners of U.S. assets will face a currency headwind. And vice versa: U.S. buyers of international assets may enjoy a currency tailwind to returns.
In our LTCMA forecasts, we simply model currencies as either under- or overvalued compared with their long-run fair value and assume a steady, linear pull to this equilibrium (EXHIBIT 9). In keeping with other public asset markets, we do not project alpha trends for currencies. However, we note that despite our linear assumption of reversion to fair value, in reality the path of currency prices can vary meaningfully from one year to the next.
We once again see the U.S. dollar as rich compared with most other currencies
EXHIBIT 9: PROJECTED EQUILIBRIUM USD EXCHANGE RATES*
Certainly some investors may view this as a potential source of alpha and for those willing to take active currency risk it may also be diversifying at portfolio level. But for the purpose of our asset return forecasts, our currency assumptions merely incorporate the impact of a linear move to fair value over our forecast horizon.
In this year’s LTCMAs, we also take a closer look at cryptocurrencies. Despite media hype and sharp price rises, crypto is not yet established as a portfolio asset. Unstable correlations to other assets mean crypto today is better thought of as a call option on a future disruptive technology than as a substitute for currencies or gold – with exposure sized accordingly.
STRONG RETURNS REQUIRE MORE THAN JUST MARKET RISK
We do see potential to achieve the kind of returns historically demanded by savers.5 Our forecasts tell us that investors can still achieve “acceptable” returns. But the portfolio required to generate these returns is dramatically different from what it has been in the past. In our LTCMA projections published after the global financial crisis, a 60/40 portfolio of global equities and U.S. aggregate bonds delivered a 7.5% return with expected volatility of 8.3%.
Today, the same 60/40 portfolio is set to return just 4.3% with volatility of 9.7%. Nevertheless, using our projections (EXHIBIT 10), we believe a return of north of 7% is still achievable even if the portfolio will look rather different: a lot more high yield debt, international stocks and alternatives, and a lot fewer government bonds. While the destination is the same, the journey is tougher, and expected volatility will inevitably be higher. Lengthening time horizons and careful liquidity planning are nonnegotiable elements of investing today. Ultimately, to push fully toward historical return levels, active allocation, manager selection and security selection will need to form some part of every investor’s toolbox.
Equity returns are quite stable compared with last year, and bond returns are a little better. But it is alternative assets that still offer the most attractive returns
EXHIBIT 10: LEFT, RETURN; RIGHT, RETURN PICKUP (PREMIUM) FOR KEY USD ASSETS
We acknowledge that the endgame is uncertain, but a bad outcome is not inevitable. Our LTCMAs represent our central expectation of what will happen over our 10- to 15-year forecast horizon, while also noting that medium-term risks have risen.
Today, many market participants focus chiefly on the risk that arises from a prolonged period of monetary and fiscal synchronization, and the implications for inflation and capital misallocation. Without doubt, the expansion of national debt, extensive fiscal stimulus, government intervention in capital markets and tolerance for negative real interest rates all have potentially harmful consequences. A disorderly and persistent jump in inflation, which forces rates higher and valuations lower, is a plausible way asset markets might reset.
But it is not the only pathway, nor is it necessarily imminent. Another potential outcome – decidedly more benign – is the effective deployment of capex and fiscal stimulus to build long-term productive capacity. In this scenario, supply grows alongside demand, keeping inflation in check and allowing for a gradual withdrawal of easy monetary policy. Government debt becomes less of a burden as the economy grows (EXHIBIT 11). Asset market valuations drift down, not because prices are falling but because corporate earnings are rising.
The period of financial repression after World War II helped shrink government debt but was over well before the inflation of the 1970s picked up
EXHIBIT 11: FINANCIAL REPRESSION AND IMBALANCES THAT LEAD TO SUSTAINED INFLATION MAY TAKE AN EXTENDED TIME TO BUILD
The reality is likely to emerge somewhere between these two extremes: A persistent inflation scare is possible, but equally, productivity is trending positively. Either way, investors should avoid the tendency to focus exclusively on a negative outcome. They should concentrate instead on building portfolios that capture today’s above-trend growth and are nimble enough to adapt as the environment evolves. Above all, investors will want to avoid assets that are serial losers across multiple potential future states of the world, and strengthen exposure to assets that are serial winners – even if this means exploring new markets and carving returns out of a wider range of risk premia (EXHIBITS 12A and 12B).
Stock-bond frontiers are similar to last year, bond returns a little better and equity little changed. Alternative assets still sit well above the stock-bond line, as they monetize risk premia such as illiquidity risk rather than market risk alone
EXHIBIT 12A: USD STOCK-BOND FRONTIERS EXHIBIT 12B: EUR STOCK-BOND FRONTIERS
The 26th annual edition explores how the legacy of the pandemic – limited economic scarring but enduring policy choices – will affect the next cycle. Despite low return expectations in public markets, we think investors can find ample risk premia to harvest if they are prepared to look beyond traditional asset classes.
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