At the turn of the calendar year, investors commonly take stock of their strategic asset allocations and make adjustments in response to changing market conditions and asset class return expectations. An eventful few months have now passed since we published our 2024 Long-Term Capital Market Assumptions (LTCMAs), but even in that brief period we have gained some additional insights that can help inform the allocation process.

For the past few years, markets have been repricing against the backdrop of a world in transition: from lower to higher rates, looser to tighter monetary policy and ample to limited liquidity. As we enter 2024, some of these trends appear to be fading, creating an environment that may produce attractive returns for diversified portfolios—but the lingering effects of recent market volatility remain.

This is not a time for static portfolio strategy. But as allocators navigate this period of transition, they should be mindful of how they sequence their exposures to key markets and seek to understand how—and why—various asset classes have responded to this new environment. In so doing, allocators can thoughtfully target sectors that have already repriced while also maintaining adequate liquidity to prepare for dislocations that have not yet emerged.

Here, we detail four high level market observations that can help guide strategic asset allocation reviews in the weeks ahead.

Observation 1: The overall investment environment is still quite attractive

Just two years ago, stock and bond markets carried historically rich valuations, and the projected return on a 60/40 stock-bond proxy portfolio was exceptionally low, at just 4.2% (a level far below most investors’ strategic targets). This lack of potential return in the public markets led to a broader use of less-liquid private alternatives as a means of closing the gap.

The rapid repricing of public markets in 2022 effectively brought forward our projection of a long period of subpar performance into a single—and exceptionally painful—year. But this repricing also left behind a far more attractive investing environment. By the time we published our 2023 LTCMAs, forecast returns across public markets had risen materially, and the projected return assumption for a 60/40 portfolio had reached 7.2% (Exhibit 1).

Since then, markets have more than fulfilled our positive expectations. The past 12 months have produced strongly positive equity returns (though gains have been more narrowly focused than expected, given exceptionally high levels of index concentration in just a handful of stocks). Bond returns lagged for most of 2023 before rallying strongly in the fourth quarter as markets began to price in declining inflation and the presumed end of the rate-hiking cycle by the Federal Reserve.

At present, the outlook for 2024 appears to offer a continuation of this positive environment. Some caution may be warranted, however, given the market’s recent strong performance, which has pulled forward some of the gains we anticipated in the most recent LTCMAs. Nonetheless, a broadly diversified portfolio should be able to reach investors’ return targets—particularly with the addition of active management and the use of diversified alternative assets. 

Observation 2: A flatter stock-bond frontier implicitly favors less risky assets

Exhibit 1 offers a clear visualization of the markets’ dramatic moves over the past few years and the impact on the risk and return of a 60/40 portfolio. We see additional subtleties revealed by public markets’ evolving relationship—specifically, the relative attractiveness of bonds and stocks (implied by the slope of the line itself) and the impact of current valuations on the equity risk premium (ERP), the excess return that investing in the stock market provides over the risk-free rate.

Thanks to the Federal Reserve’s aggressive hiking cycle and a steady decline in inflation, the bond market currently offers high nominal yields and positive real yields across the curve. Looking ahead, most sectors of the bond market are likely to benefit from this upward shift in base rates because the current yield level is typically a strong indication of future potential performance. Further, if the bond market is heading toward a secular equilibrium, in which declining inflation and falling short-term rates normalize the yield curve, additional return from capital appreciation may well be realized. Finally, the move to higher yield levels restores the potential for bonds to appreciate in the event of a growth shock, diversifying risk elsewhere in a portfolio.

The flip side of this positive relative story for bonds is that equity returns are now expected to be more modest. ERP estimates, which are widely used as an indicator of relative pricing, have fallen as bond yields and equity multiples have risen (Exhibit 2). Subtracting the 10-year U.S. Treasury yield from the earnings yield on the S&P 500 reveals the decline in the ERP from 2.2 at the start of 2022 to its current level of 0.4. While there are a variety of other ways to calculate the ERP, the directional trend is clear. 

For allocators, this evidence of the relative attractiveness of bonds over stocks should suggest a tilt towards fixed income, but only up to a point—reaching higher return targets still requires a meaningful allocation to equity or other high returning investment sectors. 

Observation 3: Seek returns from diversified sources

The classic 60/40 portfolio is essentially a “barbell” that balances volatile and high returning equities against low-risk and negatively correlated bonds. In our 2024 LTCMAs, we projected that this market portfolio could potentially deliver 7.0%, with volatility of 10%–11%, over our 10- to 15-year time horizon. While that level of return may well be adequate for many investors, the overall 60/40 strategy remains uncomfortably dependent on negative stock-bond correlation for risk management.

Although stock and bonds have become less positively correlated since 2022, we continue to witness periods of elevated correlation to both the upside and downside. With less confidence in the level of correlation going forward, investors may want to seek out more direct forms of diversification. Fortunately, the broader investment opportunity set offers a variety of asset classes that exhibit similar levels of return and risk to the 60/40 portfolio. Making greater use of these asset classes reduces investors’ dependency on market correlations for risk management.  

Exhibit 3 illustrates a broad spectrum of the investment opportunity set, including several options that may offer compelling risk and return characteristics. Each of these asset classes—high yield bonds, direct lending, and open-ended core real asset strategies in real estate, infrastructure and transportation—can potentially deliver returns at or above the stock-bond frontier with volatilities that range from high single digits to low teens. Within higher volatility equities, global strategies—and Japanese equities in particular—benefit from compelling valuations and a strong dollar tailwind.

Observation 4: The value of a dedicated liquidity strategy

While allocators tend to focus on the diversification benefits of negative stock-bond correlation, one of its less frequently discussed benefits is that it facilitates portfolio rebalancing. In a negatively correlated environment, when stocks go down, bonds go up (and vice versa), meaning that some part of the portfolio has risen in value and can be advantageously sold to restore balance. This dynamic helps investors adhere to their strategic allocations across time and also provides operational flexibility to manage cash flows. Unsurprisingly, many investors have become accustomed to using public market assets as the primary source for funding external obligations and meeting capital calls from private asset managers within the broader portfolio.

But recent history has exposed some flaws in this model.

In 2022, as sharp declines in public markets for stocks and bonds pushed asset allocations uncomfortably far from strategic targets, many portfolios experienced a “denominator effect” as the relative size of their private market allocations ballooned. Limited access to liquidity in private funds meant that rebalancing was either impossible or very costly. Although the 2023 rally in public markets has diminished these imbalances, the experience suggests that a more nuanced approach to liquidity management may be helpful. 

What would such an approach entail? First, a greater openness to operating a dedicated liquidity pool that could support a sponsor’s operational needs and manage capital calls and distributions from private funds. Cash strategies are particularly compelling at the moment, but in the long term a more sophisticated approach that includes short duration fixed income and other low-volatility sectors may be beneficial.

With this approach, broader public market portfolios—instead of serving as the primary source of funds—could then provide a secondary liquidity backstop. In extreme circumstances, investors could also consider using secondary markets to raise capital from private assets if the resulting balance would better mitigate risks across the alternative portfolio.

The inability to rebalance opportunistically and the need to source costly liquidity are flip sides of the same coin: Fully invested portfolios that rely solely on public markets as their primary liquidity source can prove vulnerable to rising correlations. Large illiquid allocations only compound the problem. Sacrificing a small amount of current return to guarantee access to liquidity may be a price worth paying.

Conclusion: Getting the most out of the strategic asset allocation process

As 2024 gets underway and portfolio allocations come under review, investors should focus on:

• Assessing prospects for reaching return targets with appropriately diversified portfolios.
• Identifying relative value across asset classes and efficiently allocating marginal capital to sectors that may exhibit more attractive near-term potential.
• Avoiding incrementalism by recognizing that allocations should not remain static over long time horizons; allocations need to respond to dynamic market conditions. 

Above all, investors should give serious consideration to changes in allocation strategy—the third point above—based on the experience of recent years. Markets’ broad repricing has lifted expectations for asset returns, and nowhere more so than in fixed income. The instability of traditional correlation relationships, however, suggests that allocators may need to implement more fundamental portfolio diversification. And the high cost of illiquidity in such volatile markets demonstrates the value of a dedicated liquidity program.

JPMAM Long Term Capital Market Assumptions: Given the complex risk-reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations. Please note that all information shown is based on qualitative analysis. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Note that these asset class and strategy assumptions are passive only–they do not consider the impact of active management. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal or tax advice.  The outputs of the assumptions are provided for illustration/discussion purposes only and are subject to significant limitations.  “Expected” or “Alpha” return estimates are subject to uncertainty and error.  For example changes in the historical data from which it is estimated will result in different implications for asset class returns.  Expected returns for each asset class conditional on an economic scenario; actual returns in the event the scenario comes to pass could be higher or lower, as they have been in the past, so an investor should not expect to achieve returns similar to the outputs shown herein.  References to future returns for either asset allocation strategies or asset classes are not promises of actual returns a client portfolio may achieve.  Because of the inherent limitations of all models, potential investors should not rely exclusively on the model when making a decision. The model cannot account for the impact that economic, market, and other factors may have on the implementation and ongoing management of an actual investment portfolio. Unlike actual portfolio outcomes, the model outcomes do not reflect actual trading, liquidity constraints, fees, expenses, taxes and other factors that could impact the future returns. The model assumptions are passive only—they do not consider the impact of active management.  A manager’s ability to achieve similar outcomes is subject to risk factors over which the manager may have no or limited control.