Higher inflation has long-lasting implications for asset-class dynamics and strategic asset allocation
There will be an increasing focus on asset classes that actually protect capital in real terms
PICTET Wealth Management recently released the 2022 edition of Horizon, our 10-year view on economies, expected returns of 53 asset classes and strategic asset allocation.
Over the next 10 years, we expect underlying gross domestic product (GDP) growth to average 2.0 per cent in the US and 1.6 per cent in Europe. We have adjusted our GDP forecast for China downwards by an average of 30 basis points over the coming 5 years (to 4.8 per cent compared with 5.1 per cent in the 2021 Horizon), while we believe Chinese GDP will grow by an annual average of 4.6 per cent over the next 10 years.
A shift towards a regime of structurally higher inflation
In all, we believe we are unlikely to return to the same low inflation dynamics we saw before the pandemic.
The global economy may face a structural increase in the direct cost of energy as well as in indirect costs such as carbon pricing and other government incentives to reduce dependence on fossil fuels. US-driven trade tariffs (particularly focused on imports from China), the global repercussions of the war in Ukraine and high global transport costs could grow the trend towards “reshoring” to limit the vulnerability of supply chains.
We estimate that structural inflation will reach a long-term annual average of 2.8 per cent in the US (versus 1.8 per cent in the years before Covid-19) and 1.9 per cent in Europe (versus 1.4 per cent in the pre-pandemic years).
Any regime shift towards higher long-term inflation would have deep and long-lasting implications for asset-class dynamics and strategic asset allocation. Investors relying on sources of fixed income could be hit especially hard. Higher long-term inflation would have consequences for monetary policy. It could also put financial stability at risk, since higher inflation tends to increase the volatility both of macroeconomic data and of the policy response.
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Rough ride ahead for holders of cash and government bonds
We expect annual average returns for the next 10 years for the vast majority of asset classes to be lower than in previous decades. Investors who choose to stay strategically invested in safe-haven assets, such as cash and core sovereign bonds, will have to bear a particularly severe erosion of capital.
We expect US cash to deliver average nominal returns of only 1.9 per cent, and euro cash only 1.2 per cent in the next 10 years. In real terms, cash could lose more than 1 per cent of its capital value each year, meaning over 10 per cent erosion in 10 years.
EM equities attractive in long run, but at additional risk
Emerging-market (EM) equities have historically delivered higher but more volatile returns than developed-market stocks. Overall, we expect a total average annual return of 7.5 per cent over the next 10 years for the MSCI EM index (in US dollars). This admittedly relies strongly on continued growth in emerging markets overall, even allowing for China’s recent slowdown, and positive support from currency movements. The asset class remains attractive over the long run, yet only for those willing to bear the additional risk.
Chinese equities a leap of faith
Despite the significant risks and complexity involved in holding Chinese equities, they remain unavoidable for emerging market investors due to the unparalleled size and depth of the Chinese market. Beyond size, Chinese equities also exhibit more diversity across sectors than any other emerging country. And given China’s economic and political clout, Chinese assets are increasingly hard to ignore for international investors. In addition, we expect the yuan to appreciate over time against the US dollar, hence providing some support to returns in hard currency terms.
Overall, we expect 10-year expected returns for Chinese equities of 7.5 per cent per annum, slightly higher than last year thanks to a better entry point, yet with a much higher geopolitical premium.
Corporate bonds: looking for carry in high yield and emerging markets
We expect the highest returns in credit to come from Asian high yield. We see EM corporate debt in general producing an annual average total return of 4.5 per cent over the next 10 years. We expect Asian (ex Japan) investment grade debt to deliver an average annual return of 4.6 per cent in US dollars, while we expect riskier Asian (ex Japan) high yield to deliver 6.8 per cent.
China (including Hong Kong) continues to dominate Asian (ex Japan) corporate bond indexes and issuance, accounting for about 54 per cent of Asian corporate bonds outstanding. This dominance may grow further in the years ahead.
Real assets and private assets should continue to deliver superior but lower returns
Real assets and private equity should continue to deliver superior returns, but our new forecast is that annual returns will not reach double digits. Private equity has historically posted a 15 per cent annual return, but we expect it to deliver “only” 9.2 per cent in the next 10 years.
There are 3 main reasons for this decline: valuations are high, funding costs will increase, and private equity is becoming an overcrowded asset class. The ability of individual private-equity managers to adapt their investment strategies and choose the best buyout targets could push returns higher than our forecast.
A number of real asset classes are still attractive as alternatives to bonds, including real estate. An increase in rates due to inflation will also put pressure on real estate valuations, but should support cash flows as property rents are generally indexed to inflation (usually the consumer price index). Real estate therefore has a positive correlation with inflation.
We expect annual average returns of 5.6 per cent from core real estate and 5.9 per cent from core infrastructure, with the bulk of returns generated by yield.
Higher inflation should increase the attraction of the endowment style
There will be an increasing focus on asset allocations built around asset classes that actually protect capital in real terms. According to our research, real assets — a mainstay of endowment fund allocations — fit the bill. The prospect of higher structural inflation enhances the argument for the endowment-style approach to investing.
The increasing sources of financial instability, the changing inflation regime, the need to increase allocations to real assets all require a very precise definition of investor objectives. Among the different parameters used to define investors’ profiles, their objective in terms of real profitability remains key, alongside their investment horizon and their willingness to take on risk.
The writer is Pictet Wealth Management Asia’s head of Asia investments.
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