A likely brighter outlook for 2023
2022 is one for the history books. The outbreak of the Covid-19 pandemic in early 2020s triggered a short but severe recession together with supply chain disruption around the world. This was followed by strong fiscal responses from governments and ultraloose monetary policy, which fuelled the highest inflation since the 1980s. Central banks around the world, led by the US Federal Reserve, embarked on the fastest pace of monetary tightening in decades to fight inflation, driving sharp losses across major asset classes.
For only the 4th calendar year in the past 150 years, we saw both bonds and equities declining concurrently. This meant a 60/40 equity/bond portfolio suffered a c.17% loss, its 4th worst calendar year decline historically, as stock/bond correlation turned positive. While the macro environment could remain challenging and inflation has yet been defeated, a review of our long-term capital market assumptions is delivering a brighter message: Markets today offer some of the best potential for long-term returns since 2010, potential short-term declines notwithstanding.
So what changed?
A review of our long-term return expectations on asset markets have improved markedly from a year ago. The sharp unwinding of negative policy rates across the world pushed bond yields higher and equity valuations lower. This means our expected returns for a 60/40 equity/bond portfolio for the next 7 years have leapt from 3.6% last year to 5.9% this year, providing investors more scope to achieve their returns objectives. Today’s markets offer one of the best returns opportunity sets for long-term investors, in our view.
Volatility, however, have also risen across most asset classes. The recent trend of increased short-term volatility across asset classes is a result of rapidly rising inflation. The resulting tightening of monetary policy impacted asset prices, particularly bonds. Some of these impacts may persist as policymakers either hike further or keep rates elevated, which means the risk of further volatility or a temporary jump in positive correlation between stocks and bonds remains possible. While not our base expectations, a prolonged shift towards positive stock-bond correlation, may reduce an investor’s capacity to safely hold equity risk.
With higher cash rates and starting yields, expected returns on most bond asset classes have improved, with DM IG Corporate, DM High yield and EM bonds expected to deliver 4.8%, 6.9% and 7.1%, respectively, with higher volatility expected. At the time of writing, markets are concerned about an impending US recession. While HY spreads may rise higher in a recessionary scenario, default rates are likely to remain stable, given limited refinancing needs and the up shift in quality seen in the HY segment over the past few years.
In terms, of equity, expected returns have risen meaningfully compared to a year ago on better starting valuations after the sharp fall in prices last year. Corporate profitability remains near an all-time high, with margins remaining at elevated levels despite the rise in input and labour costs. An aging demographic and lifestyle changes post pandemic has likely led to structurally lower labour participation and a tighter labour market, presenting risks to corporate margins longer term. Despite this potential margin headwind, equities still expect to deliver the highest return among risk assets.
As a gauge, expected returns on DM (developed market) Equities and EM (emerging market) Equities is revised up by 180bp and 120bp, to 6.9% and 9%, respectively, narrowing the returns differential between DM and EM this year. EM equity is expected to enjoy higher returns but also much higher volatility versus their DM peers.
Lastly but not least, Alternative strategies are still expected to deliver solid returns, and value from a diversification standpoint. Higher risk asset volatility and cross-dispersion among risk assets improve the potential for alpha generation. Higher interest rates tend to be positive for most hedge fund strategies and help them deliver less correlated returns while dampening portfolio volatility.
What does this mean for portfolios?
Unlike the end of 2021, a baseline 60/40 global equity bond equity allocation can now achieve returns nearing 6%, before incorporating any asset optimisation or alternative assets. This means investors now have greater scope of achieving their portfolios objectives given the improvements to long-term expected returns.
Alternative strategies offer value for diversification
The experience in 2022, where bonds and equities sold off concurrently, illustrates the importance of diversification that alternatives can provide in investment portfolios. Although Alternatives assets are not as critical as they were in end-2021 to achieving higher returns, it is now even more important from a diversification perspective. A sustained rise in stock-bond correlation seen last year makes a 60/40 stock bond allocation riskier, even if returns are now more compelling. In this scenario, bonds become less diversifying for the same level of equity allocation.
Hence, while the risk-adjusted returns (sharpe ratio) for Alternative strategies are relatively more stable than the improvement witnessed for both equities and bonds this year, Alternatives would still be an important asset class to manage portfolio volatility as well as potentially enhancing returns.
Correlation drives optimal stock-bond allocation, but not the only a means to an end
Stock-bond correlation is an important consideration in how much equity risk an investor can take without creating too much portfolio volatility. A sustained negative correlation between stocks and bonds can allow an investor to hold more equity risk in its portfolio. Conversely, in a scenario of positively correlated stock-bond correlation, an intuitive reaction may be to reduce the allocation to equity at the expenses of bonds. This, however, may not be an optimal approach as a reduced weight to equity would reduce expected returns long-term as well. A more optimal approach may to dynamically manage the allocation to equity, through strategies which can take into account the risks of any sudden spike in correlations. This is where a diversified allocation, including alternatives, can play a role.
Brighter outlook for long-term investors
With the improvement in expected returns for asset markets, 2023 is likely to deliver a brighter outlook for long-term investors. While there could be further policy tightening and downside risks to asset markets, it is important for investors to focus on the long-term, fortifying their investment portfolio as asset markets go on sale. The returns outlook I outlined above can provide investors with a long-term north star, helping one to mitigate emotional biases and avoid reacting excessively to short-term market moves, instead, focusing on long-term value created by the sell-offs.
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