The next decade – a changed landscape for strategic asset allocations

IN OUR latest edition of Horizon, our 10-year view on economies, return projections across 56 asset classes and strategic asset allocations, the overarching theme is scarcity, and what the various forms of scarcity – of resources, commodities, labour – and growing political polarisation mean for investment decisions.

We believe that the economic and political framework of the past decade is gone, leading to a very different investment landscape that calls for a changed approach to asset allocation.

Scarcity of natural resources and labour weighs on growth and drives inflation

Increasing competition for natural resources and the drop in working-age populations across most major economies will be key issues in the next decade. Scarcities of these sorts will affect economic growth potential and put upward pressure on inflation, which we believe will remain structurally higher than before the pandemic.

Horizon’s longer-term forecasts see growth slowing, with global gross domestic product (GDP) growth expected to average 3.1 per cent over the next 10 years.

Among major economies, we forecast annual GDP growth for the US to average 1.7 per cent over the next decade, headline consumer price index in the US to reach an annual average of 2.7 per cent and the Fed funds rate to converge towards a level of 2.5 per cent.

Our 10-year annual growth forecast for the euro area economy is 1.5 per cent, structural inflation in the euro area to reach 2.1 per cent on average and the European Central Bank’s deposit rate to average 2.5 per cent.

China’s growth potential over the next 10 years is compromised by rapid ageing of its population, slowing urbanisation, deglobalisation and the US’ efforts to hem in its access to cutting-edge technologies.

A slowdown in housing-related activity could impact China’s growth. We now see Chinese GDP growing at an annual average of about 4 per cent over the next 10 years, and annual inflation at 3.2 per cent. We expect real GDP growth of 0.9 per cent per annum on average in Japan over the next decade, along with a gradual normalisation of Bank of Japan monetary policies.

We feel that India may be able to reap a demographic dividend over the next decade, and raised our forecast for Indian GDP growth to an annual average of 6.2 per cent over the next 10 years.

New style of monetary policy

Against this macroeconomic backdrop, we envisage a slow normalisation of fiscal and monetary policies that occasionally leads to periods of financial instability.

We believe central banks’ capacity and appetite for supplying more liquidity to markets, whether through lowering rates or through buying debt, will be more limited. This means excessive indebtedness could move back to the top of the agenda, with prudence re-emerging as the focus in strategic allocations and a move away from risk-taking built on leverage.

In such circumstances, we might be able to look forward to a revival of the time-tested 60:40 portfolio, splitting between 60 per cent stocks and 40 per cent bonds, balancing the higher risk and higher return potential of stocks with the lower risk and stability of bonds.

Despite the increase in the outlook for inflation, the macroeconomic backdrop remains favourable for 60:40 portfolios over the coming decade. Our forecast that bond yields will remain higher than in the past suggests bonds will once again be a viable source of positive real income and a potential buffer against downside risk in equities.

But equities are looking more attractive compared with last year due to the fall in valuations. The combination of these two factors means that markets could potentially offer better long-term returns over the next decade than we forecast last year.

Corporate margins will come under increasing pressure

The capital expenditures involved in securing supply chains; the chance that workers gain the upper hand against management; and the overall cost of deglobalisation will play a role in pushing corporate margins down in the next decade.

Interest rates and taxes are other factors. We believe corporations will really begin to feel the effect of central banks’ rate-hiking campaigns on their funding costs in 2024.

Corporations will also face increasing tax pressure. This means investors will have to double down on the most resilient sectors and companies – those with “pricing power”. The decline in margins is factored into our return expectations for developed-market equities.

Our forecast is that margins will suffer more in the US than in Europe. US equities are expected to deliver an annual total return of 6.2 per cent over the next decade, lower than European equities at 7.3 per cent.

Fixed income to provide decent carry again

We believe bond yields will be higher than in recent years as above-target inflation obliges central banks to maintain a tough policy stance, and this is unlikely to be fully reversed. Thus, we expect nominal total returns from government bonds to range between 0.1 per cent (for Japanese government bonds) and 3.7 per cent (for US Treasuries) on average over a 10-year horizon.

Wider spreads and higher government bond yields lead us to raise our 10-year return expectations for credit.

We expect the most attractive risk-adjusted returns to come from investment grade, and now expect average annual returns of close to 5 per cent over the next 10 years for US and euro investment-grade corporate bonds alike. Their riskier high-yield counterparts could return around 7 per cent.

We forecast Asian (ex-Japan) investment-grade debt to deliver a similar return (6.1 per cent in US dollars) while the return from riskier Asian (ex-Japan) high yield may be only moderately higher (7.2 per cent), because of a still-elevated loss ratio of 2.8 per cent.

China (including Hong Kong) continues to dominate Asian (ex-Japan) corporate bond indexes and issuance, accounting for about half of Asian corporate bonds outstanding.

This dominance may grow further in the years ahead. We believe the Chinese authorities’ bid to bring indebtedness under control and to limit state liabilities will have a significant impact on the growth of Chinese high yield, particularly in the real-estate sector.

Endowment style of investing with allocation to alternative assets retains its potential

The endowment style of investing is characterised by a focus on the pursuit of superior long-term returns and an ability to tolerate significant short-term volatility. This involves significant investments in alternative assets (including private equity, hedge funds and real assets) at the expense of more liquid instruments such as stocks and bonds.

While they were not unaffected, US endowment funds’ exposure to alternatives cushioned their performance in 2022, with an average negative return of 8 per cent, compared with the dramatic decline in both equity and bond markets, where the S&P 500 Index fell 24 per cent and 10-year US Treasuries tumbled 17 per cent.

We expect that an endowment approach will stand investors in good stead in the years ahead, in a climate marked by higher interest rates and more volatile inflation than before.

Among alternative assets, we expect private equity to produce the largest annual returns of any asset class over the next 10 years, both in real (6.4 per cent) and nominal terms (9 per cent).

The writer is Asia chief investment officer and head of discretionary portfolio management at Pictet Wealth Management.