Long-term return expectations give clues on how to invest, but are not infallible

ONE of the major headlines that caught people’s attention recently was the dramatic increase in famed US holding company Berkshire Hathaway’s cash position. It stands at around 28 per cent of assets, the highest since at least 1990.

As a value investor, CEO and chairman Warren Buffett’s decision to continue to raise cash is a sign that he believes markets are very frothy and expensive. This is also borne out by our forthcoming update of long-term expected returns, which are based on the outlook for growth, inflation and other economic variables. The expected returns make the case that bonds should be favoured over equities.

For instance, the expected return on US equities over the next five years has fallen to 5.2 per cent per annum from 5.7 per cent a year ago. Once you compare this to 4.7 per cent for US government bonds, a similar return for much lower volatility, this suggests that you should allocate a lot more to bonds relative to equities in the past.

However, higher-than-normal inflation in the post-Covid world suggests the real returns on bonds will be muted. Meanwhile, the portfolio diversification benefits of holding equities and bonds are reduced at higher levels of inflation. This will leave many wondering whether they should just sit on the sidelines in cash and wait for value to be created.

This is the wrong conclusion to draw. The first thing to emphasise is that expected returns are just that – expected. They are not infallible. Indeed, US equities have defied expensive valuations and return expectations for most of the past 10 to 15 years.

Of course, it is possible that this will come to bite investors at some point. Indeed, it would be surprising if US equities did not experience a bear market at some point in the next five years. However, trying to time this is incredibly challenging, even for professional investors.

Outlook for inflation and bonds

The second thing to note relates to inflation. A couple of US investment banks have suggested that bonds no longer offer value in a world where inflation is likely to be higher than in the decade following the 2008-09 global financial crisis. From our perspective, this is a valid concern – at least to some degree.

Inflation looks likely to be higher for longer with a Republican clean sweep in the recent US elections – which is likely to lead to increased import tariffs, a less business-friendly immigration system and tax cuts. On paper, these could be inflationary in an economy which has limited spare capacity and ability to substitute imports with onshore production.

However, bond yields are already pricing in at least some of this risk – the 10-year US government bond yield has risen from 3.6 per cent in mid-September to 4.4 per cent recently. This is significantly above most projections for inflation.

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The final concern is that if inflation is above 3 per cent, then the correlation between bonds and equities generally flips to positive – that is, equity and bond prices would generally move together. This reduces the portfolio diversification benefits of adding bonds to an equity-laden portfolio. All this sounds rather depressing.

What should an investor do?

My advice would be not to sweat the small stuff. Yes, these topics do seem to have important implications for investors, but they are uncertain. Nobody knows what is going to happen. Moreover, markets have an impressive knack of pricing risks speedily and thus, providing decent returns for investors. Worrying excessively about what might happen risks “analysis paralysis” that leaves you trapped in low-yielding cash, which is generally not a good place to protect against inflation.

The answer, in my opinion, is to stick to a plan of investing regularly in different asset classes. Equities provide a long-term hedge against inflation. This is a key argument for maintaining a sizeable allocation in your portfolio against the current backdrop.

Gold also can provide a hedge against inflation, although it does not provide inflation-adjusted cashflows the way equities do. Therefore, we maintain a smaller 5 to 10 per cent allocation in our foundation portfolios. Bonds still warrant an allocation as they are still likely to provide some diversification benefits and yields above the inflation rate.

Alternative assets to boost returns

However, wherever possible, you should also look to diversify to other areas of the market. Private debt and private equity have long-term expected return of around 9 per cent. Therefore, they add to the expected return of an overall portfolio and reduce its volatility slightly due to diversification benefits. The risk here, especially in private equity, is accessing the right investment opportunity as the dispersion of returns delivered by different managers increases dramatically relative to most public market assets.

Real estate is also an interesting area to consider. While expected returns are lower than elsewhere, both in public and private markets, they do offer inflation-hedged cash flows which is a desirable characteristic in the best of times, and potentially even more so today.

If we move back to basics of why investing is important, it makes the desirable investment plan clearer. There are two simple objectives in my opinion.

First, protect against inflation, which over long periods of time massively reduces the value of money. Second, to grow wealth beyond the level of inflation via compounding.

What our long-term expected returns are suggesting is that the likely rate of compounding is lower. However, we would argue that the first reason – inflation – is even more important than it has been for the past 15 years. This warrants a significant allocation to inflation-protected assets, including equities.

The writer is global chief investment officer at Standard Chartered Bank’s Wealth Solutions unit