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Even in the most favourable of economic and financial market environments, investing is a precarious activity. Trying to predict future events and combine a mix of investments to suit that particular narrative is the trap to avoid. As recent geopolitical developments highlight, it’s exceptionally difficult to anticipate how world events may evolve, and the temptation after a steep fall in markets is to reduce risk by selling equities.
A better, more straightforward approach is to estimate long-term returns by asset class and allocate the optimal mix of different investments to construct a portfolio that maximises potential future returns for a given level of risk. As central banks abandon policies that have suppressed market volatility in recent years, forming an opinion on future volatility and how the correlations between different asset classes are likely to evolve is an important part of the process.
For assets that benefit from economic growth – particularly equities – we combine an analysis of historical inflation-adjusted returns with expectations of long-term economic growth, inflation, risk premia, and current valuation measures. The metrics support our view that equities should return 3-4% above inflation over the next 10 years, somewhat less than we have seen since 2012.
For defensive assets – principally bonds – we consider low starting yields, the progressive unwinding of central bank quantitative easing and the future inflation-growth trade-off. This leads us to believe that bonds will struggle to match inflation over the next decade, and after 3 years of strong returns, we are starting to reduce the interest rate and credit sensitivity of our bond portfolio.
Therefore, over the next decade, the inflation-adjusted return of a traditional balanced 60/40 equity bond portfolio is unlikely to rise above 2%, considerably lower than that recorded since 2012. So, while this long-term strategic approach to asset allocation removes the risk of short-term price volatility, the promise of returns appears moderate at best.
A solution to boosting returns in a balanced portfolio is to introduce hybrid investments into the asset mix at the expense of traditional fixed income. At The People’s Pension, our default investment option invests nearly 67% in equities, 20% in bonds, and the rest in real estate and infrastructure investments. These latter 2 asset classes have both equity and bond-like characteristics as they participate in the benefits of economic growth and pricing power while also generating income. There is also evidence that they can provide some protection against inflation.
Within our equity allocation, we also make use of risk premia strategies – which comprise value, momentum, quality, size, and low volatility – and use a rules-based approach to benefit from market inefficiencies caused by investors’ various cognitive biases. We incorporate these strategies in a low-cost way within our members’ overall asset allocation.
We estimate that introducing hybrid assets and a risk premia approach should boost the long-term real return to around 3%, a better return compared to a traditional balanced portfolio. Clearly, there is no guarantee of future returns, and a combination of geopolitical uncertainty, elevated energy prices, and ongoing supply-side constraints is likely to lead to prolonged volatility, potentially whipsawing those brave investors keen to trade markets tactically.
Looking ahead, after a weak start to the year, our base case is that economic growth will accelerate as we head through 2022. However, inflation will remain a significant margin above the key central banks’ targets, and with wage growth lagging, real incomes will be squeezed.
This time round, central banks will not be able to ‘look through’ unfavourable inflationary outcomes and there will be monetary policy tightening. Higher interest rates will be driven primarily by the authorities’ desire to ensure inflation expectations do not drift and cause a repeat of the 1970’s experience.
Currently, financial markets are giving central banks the benefit of the doubt in their attempt to engineer a soft landing for inflation in 2023 while maintaining reasonable economic growth, and this remains our baseline scenario. If this occurs, financial markets should recover lost ground as we head through this year. However, if central banks lose control of the inflationary narrative, expect further weakness in markets.