Let’s start with the bad news: financial assets have performed extremely poorly in 2022. The total return from global stocks is -25% through three quarters of the year. Global sovereign bonds and credit haven’t fared much better either, each with total returns of -21% over this same period, says Evan Brown, Head of Multi Asset Strategy Investment Solutions at UBS Asset Management in his latest Macro Monthly.
The negative stock-bond correlation that prevailed through much of the past 25 years, which helped to simplify portfolio construction, has reversed in the face of persistently elevated inflation and aggressive central bank tightening campaigns. As of mid-October, the year-to-date return from a portfolio with a 60% weighting to US stocks and 40% weighting to US Treasuries is nearly -20% (see Exhibit 1). There have only been three calendar years on record in which the annual performance for this traditional portfolio structure has been worse – and all were more than 80 years ago.
We acknowledge that the near-term macro outlook is unusually uncertain, with a negative skew for economic activity. But we believe the inflation, growth, and geopolitical factors that have caused market strife in 2022 are increasing the potential rewards for medium and long-term investors willing to bear these risks. This is the good news about bad markets.
We develop capital market expectations, which are projections for how we believe that different asset classes will perform over five years given our assumptions for growth, inflation, monetary policy, and other key macro factors. These estimates show that now is a much more attractive investing backdrop compared to 12-15 months ago. In our baseline scenario, expected five-year annual returns for a global 60/40 portfolio are now 7.2%, vs. 3.3% in July 2021, while real (that is, inflation adjusted) returns are 4.4% vs 1.2% (Exhibit 2).
This is the best outlook for returns since at least the fourth quarter of 2018.
Key changes to our assumptions
The main driver of better expected returns across asset classes is the improvement in valuations relative to those embedded in our capital market assumptions from mid-year 2021. More favorable valuations, while retaining a similar outlook for real activity, naturally entail higher return expectations, all else being equal. Our expected return on cash has increased substantially, from less than 1.0% to 3.7%, following substantial interest rate hikes by central banks. The extent of monetary tightening is linked to another change in our estimates: the average outlook for inflation over this horizon, which has risen from near 2% to close to 3%. Importantly, while more robust price pressures help improve nominal expected returns, expected real (inflation-adjusted) returns across asset classes have also improved materially.
Currencies are another key consideration. The US dollar has become even more expensive over the past year, which in our projections increases the expected depreciation over time as it reverts towards fair value. We believe this is poised to boost returns for USD-based investors who hold international assets over a five-year horizon.
Across the major liquid asset class of equities, government bonds, and credit, our baseline outlook for expected returns is meaningfully higher as of September 2022 than in July 2021 (Exhibit 3). The improvement in the return profile is most evident in assets that pay a coupon – government bonds and credit – a function of the higher starting point for risk-free rates.
The end of the TINA era (“there is no alternative” besides stocks) is not primarily a bad news story for equities, in our view – it’s a good-news story on the outlook for multi-asset portfolios. Diversification may now be achieved in concert with positive expected returns across asset classes. That we have entered a regime in which there are many different ways to make money is a development perhaps best illustrated by the dwindling stock of negative-yielding debt globally (Exhibit 4).
We also explore how sensitive our return expectations are to different mixes of growth and inflation over two-year and fiveyear time frames:
- Deep recession: lower inflation, lower (or negative) growth.
- Stagflation: a sustained period of above trend inflation and below-trend growth.
- Goldilocks: a moderation of inflation along with above-trend growth.
- Reflation: above-trend inflation and above-trend growth.
As shown in the previous section, the global 60/40 portfolio has a nominal expected annual return of 7.2% and a real expected annual return of 4.4% over the next five years in our baseline projection. Over a two-year horizon, however, the range of possible outcomes remains wide. In the goldilocks and reflation outcomes, expected real returns are in the high single digits (double digits in nominal terms). But in the event of a deep recession or stagflation, expected real returns are negative. Over a five-year time frame, stagflation is the only scenario in which expected real returns are negative (-5.8%), with a prolonged positive stock-bond correlation that challenges performance in all parts of the portfolio. Real five-year expected annual returns are modestly positive even in a deep recession (0.2%), while expected annual real returns are 5.0% and 7.0% in the goldilocks and reflation scenarios, respectively.
Over a five-year time frame, stagflation is the only scenario in which expected real returns are negative (-5.8%), with a prolonged positive stock-bond correlation that challenges performance in all parts of the portfolio. Real five-year expected annual returns are modestly positive even in a deep recession (0.2%), while expected annual real returns are 5.0% and 7.0% in the goldilocks and reflation scenarios, respectively.