The market drawdown in 2022 is creating an increasingly attractive entry point for long-term investors.
Back to Basics
Lower valuations and higher yields mean that asset markets today offer the best long-term returns in more than a decade. It took a painful slump in stock and bond markets to get here, and the worst may not yet be over.
But after a year of turmoil, the core principles of investing still hold firm. Once again, 60/40 can form the bedrock of portfolios, while alternatives can offer alpha, inflation protection and diversification. Meanwhile, the end of free money, greater two-way risk in inflation and policy, and increased return dispersion across assets also give active managers more to swing for.
In the near term, investors face a challenging time as a recession, or at least several quarters of subtrend growth, lie immediately ahead. Still, our assessment of long-term trend growth is only marginally below last year’s. We expect today’s inflationary surge to eventually subside to a rate only slightly above our previous estimates.
Bonds normalize, stock forecasts soar
Our forecast annual return for a USD 60/40 stock-bond portfolio over the next 10–15 years leaps from 4.30% last year to 7.20%.
After policy rates normalized swiftly, bonds no longer look like serial losers. Once again, they offer a plausible source of income as well as diversification. Higher riskless rates also translate to improved credit return forecasts.
Projected equity returns rise sharply. In local currency terms, our developed market equity forecast rises 340 basis points (bps), to 7.80% , and in emerging markets jumps 230 bps, to 8.90%. Corporate profit margins will likely recede from today’s levels, but not revert completely to their long-term average.
Stock and bond valuations present an attractive entry point. Alternatives still offer benefits (diversification, risk reduction) not easily found elsewhere. With the U.S. dollar more overvalued than at any time since the 1980s, the FX translation will be a significant component of forecast returns.
Scarce capital, surging demand for capex
Many long-term themes affecting our outlook (demographics, shifts in globalization patterns) will demand higher capital investment – paradoxically just as the abundance of cheap capital of the last decade is reversing. As financial markets look to efficiently allocate scarce capital, the result may be more idiosyncratic returns, and lower correlations within indices.
Overall, the return outlook in this year’s Long-Term Capital Market Assumptions stands in stark contrast to last year’s. Headwinds from low yields and high valuations have dissipated or even reversed, and asset return forecasts might be considered “back at par.”
Asset reset, attractive entry point
It has taken a meaningful reset in asset markets to bring us to this place, and considerable pain for bondholders over a much shorter horizon than we had expected. Still, the underlying patterns of economic growth look stable, and the assumptions that underpin asset returns – cycle-neutral real cash rates, curve shape, default and recovery rates, and margin expectations – are little altered.
But the market drawdown in 2022 is now creating an increasingly attractive entry point for long-term investors. While 2022 was a painful ride as long-standing dislocations closed sharply, investors can now look forward to compounding future returns at much more attractive levels.
The assumptions are not designed to inform short term tactical allocation decisions. Our assumptions process is carefully calibrated and constructed to aid investors with strategic asset allocation or policy-level decisions over a 10- to 15-year investment horizon.
Our assumptions can be used to:
Develop or review a strategic asset allocation
Understand the risk and return trade-offs across and within asset classes and regions
Assess the risk characteristics of a strategic asset allocation
Review relative value allocation decisions
Download matrix by currency
These articles look into issues likely to have a profound and protracted impact on the global investment landscape.
In a new macroeconomic regime, investors can stress-test their allocation process and make changes that will support risk-adjusted returns over multiple horizons.
Striking a balance: Strategic patience, tactical flexibility
The year 2022 marks a regime shift – from a world of low inflation and easy financial conditions to one of high inflation, tightening policy and higher interest rates. The emergence of this new regime presents an opportunity for investors to stress-test their allocation process and implement changes that will support risk-adjusted returns over multiple horizons.
A transformed investment environment requires a clear-eyed assessment of the longer-term assumptions that anchor the strategic allocation process. It also suggests a more flexible approach to short-term tactics, as recent market shifts offer opportunities to manage risk and capture returns in the near term. Investors need to strike a balance between strategic patience and tactical flexibility.
Adjusting allocation strategies
During the past year we observed a significant shift in the dynamics of asset allocation. Diversification within public markets disappeared as stocks and bonds declined in lockstep. The relative outperformance of private assets led to allocation imbalances. And finally the forceful policy response to rising inflation upended traditional yield curve and currency dynamics.
If these trends persist, strategies will need to adjust. Even if they are temporary, these trends may offer compelling tactical opportunities. We use an allocation model, adjusted for higher correlations and the latest return assumptions, to illustrate the directional tilts that could make sense.
Among our key conclusions: Given the improvement in forward return assumptions for public markets, a “baseline” 60/40 portfolio may deliver higher forward returns than at any time in more than a decade. In response to a stronger dollar, global investments may prove attractive to U.S.-based investors (and U.S. investments correspondingly less attractive to non-U.S. investors).
Caution is required, however, as the potential for a shift to a more positively correlated environment may limit an investor’s capacity to diversify equity risk and may increase volatility. As a result, increased exposure to lower volatility credit sectors and diversified alternatives may be needed to balance risk and return at the portfolio level.
The expanding role for diversified alternatives
Alternatives may be less critical to reaching forward return targets than they were at the end of 2021. But they are now even more important from a diversification standpoint. Diversified alternative allocations offer a compelling mix of lower absolute volatility as well as a reliable source of returns.
Our model allocates broadly across private equity, global core real estate, infrastructure, diversified hedge funds and direct lending. In our view, investors should consider allocating as much to these assets as their liquidity budgets prudently allow.
Examine our return projections by major asset class and the thinking behind the numbers.