At the end of 2021, with the coronavirus racing back on
to the stage for an unexpected encore, global audiences
were increasingly looking to treat it as background noise –
but transitions can be tricky. Inflation in major economies
has recently hit levels not seen for 10 years, and the world
is finally waking up to the stark choices presented by the
climate emergency. Although we expect the coming years to
see the reappearance of many elements of pre-pandemic
economic life, this is not a return to the “old normal”.
In this paper we set out our expectations for what this could mean for investors
over the next five years and in the long run; these capital market assumptions form
the base case we use when constructing strategic asset allocations for our clients.
We also highlight some key uncertainties, which also form part of our portfolio
construction process.
Return drivers
Over the long term we believe asset class returns are driven by their exposure to
fundamental macroeconomic risk factors. These include broad economic growth and
inflation, as well as the premia that investors demand for bearing market-related risks
such as illiquidity, providing long-term funding and a lack of investment transparency.
In the medium term, changes in market valuations are an important additional
source of return.
GDP Growth (%)
Source: IMF, as at October 2021.
Government 10-year bond yields (%)
Source: Bloomberg, data as at 31 December 2021. Past performance does not guarantee future results.
It is not possible to invest directly in an index.
It is not possible to invest directly in an index.
2021 was a period of very strong returns in markets, with growth in part
fuelled by significant support from monetary and fiscal policy. But the
immediate crisis of the pandemic is coming to an end in many places and
inflation has begun to pick up. While some of this is a “base effect” – ie, the
result of comparing prices with their lows experienced during the pandemic
– there have been real difficulties faced by supply chains struggling to cope
with renewed demand. We therefore foresee reductions in monetary stimulus
over the next five years. Central banks are beginning the task of increasing
interest rates, albeit not to pre-2008 levels. However, while there are risks,
we do not expect economic growth to stall. Indeed, we expect it to slow but
remain above trend long-term growth over the next five years.
Rising yields necessarily have a significant impact on valuations of fixed
income assets. While we believe government bonds should be most
impacted, we expect credit to be buoyed by underlying economic growth.
In equities, valuations are not yet stretched – especially outside of the US –
when the low level of interest rates is taken into account.
The overall prospect for the next five years, therefore, is one in which we
still see equities being attractive relative to long-run averages, especially in
developed markets outside the US and in emerging markets. In contrast,
we expect bonds, especially government bonds, to struggle as the long bull
run in yields is replaced by a slow and steady uptick. Investors will therefore
need to look beyond the usual places for diversification in this period.
For this we continue to favour non-traditional markets such as property,
infrastructure and private assets, which are partly driven by different risk
premia such as illiquidity and where attractive valuations can still be found.
Potential risks
Assets are certain to diverge from our central forecasts, so it is useful to
consider scenarios in which these divergences could be material: what are
the tail risks that could upset our estimates? By keeping an eye on these
scenarios and ensuring portfolios are not unduly exposed to them, we can
build better portfolios.
We expect steady rises in interest rates and economic growth to be stable,
and while inflation may reach high levels it will settle back close to central
bank targets. It is possible – though less likely, in our view – that inflation is
not transitory and that banks then feel forced to take more robust action to
rein-in prices. It would be easy in such a scenario for monetary policy to be
too tough, and the result may be that economic growth is stifled.
Inflation rate (%)
Source: IMF, as at October 2021.
We view economic growth in the coming years as a global phenomenon, as
countries resurface from pandemic-driven lockdowns and invest in a green
transition to prevent severe global warming. Yet countries are working to
their own timetables and take different approaches. While many western
nations are relying on vaccinations to chart a path towards a world of living
with Covid-19, China has to-date taken a notably different zero-tolerance
approach. Broader policy divergence between the US and China, for example,
could act as a brake on economic growth.
More generally, geopolitical tensions have the potential to disturb the smooth
running of economies and markets. As well as US-China competition, the
ongoing tensions between the UK and the EU or, more seriously between
Russia and Ukraine or North and South Korea, are all capable of flaring up.
The effects are difficult to predict, but we suggest holding a well-diversified
portfolio and some US dollar exposure should help investors mitigate the
worst portfolio impacts in these scenarios.
Summary
We expect the transition from falling yields to rising yields to be challenging
for markets. We see good underlying growth prospects providing a tailwind
to assets oriented to economic activity such as equities – and that these
assets are not yet constrained by stretched valuations. However, we believe
fixed income will no longer be the most natural balancer for portfolios biased
towards these assets: government bonds will struggle in the coming years.
In our view, alternative return sources linked to infrastructure, private assets
and the green transition present more attractive diversification opportunities.
Our latest capital market assumptions
Arithmetic returns shown are in GBP, USD and EUR
Note that expected returns represent the average return of each asset class, excluding any contribution from
stock selection where an investment or portfolio is managed actively. This is especially relevant when investing
in private markets where the risks and returns related to the particular investment or manager can easily
overshadow the market-related components. The specific characteristics of such investments therefore need
to be given careful consideration.
Notes on index proxies used: UK gilts: FTSE Actuaries 5-15y Gilts; US treasuries: ICE BofAML 5-10y treasuries;
Euro government bonds: Bloomberg Euro Government Bond 5-7yr Term Index; UK corporate bonds: iBoxx Sterling
Non-Gilts 5-10y; US corporate bonds: ICEBofAML US Corporates; Euro corporate bonds: ICE BofAML Euro
Non-Sovereign; US high yield: ICE BofAML US High Yield; Global high yield: Bloomberg Barclays Global high yield;
Private debt: Preqin Private debt; Emerging market debt (USD): JPM Global EMBI; Emerging market debt (local ccy):
JPM GBI-EM Global Diversified; UK equities: FTSE 100; US equities (large cap): S&P 500; US equities (small
cap): Russell 2000; Euro ex-UK equities: MSCI Europe ex UK; Japanese equities: MSCI Japan; APAC ex-Japan
equities: MSCI APAC ex Japan; Emerging market equities: MSCI emerging markets; Developed equities: MSCI
World; Global equities: MSCI ACWI; Private equities: Preqin Private Equity; Commodities: Bloomberg Commodities
total return. Bespoke proxies used for global infrastructure equities, US property and diversified hedge funds
using BlackRock Aladdin.
