With various geopolitical events buffeting the global financial markets and an economic recession expected in the next 20 months, forecasting how an investment portfolio will perform in the long term has become more challenging. In this scenario, valuations may be the key towards more accurately predicting how asset classes will perform.
“Everyone knows that valuations are not terribly useful for telling you anything about the next 12 months’ returns. But they are very useful for telling you about the next 10 years’ return,” says Christopher Mahon, investment manager and director of Asset Allocation Research, Multi Asset Group at Barings, which prepares a 10-year forecast for multi-asset portfolios.
Although valuations have improved over the past 12 months for many asset classes, they are still not cheap versus a long-term history. Most asset class valuations have only a limited buffer against losses from an economic recession taking place over the next ten years.
“It is valuations, not economics, which present the more meaningful headwind to long-term returns from today’s starting point. Investors will need to be more dynamic and selective about asset classes. Over the past 30 years, a traditional balanced strategy delivered an annual return of around 8% per annum. For the next ten years, a static balanced portfolio will most likely deliver less than 3% per annum,” Mahon says.
Some of the asset classes with higher return forecasts can be found within the credit space. Sub-investment grade credit markets have the potential to do well, even allowing for the likely level of defaults and the probability that spreads will rise from their current levels.
While government bond yields could back up from here, the magnitude of any such move is well contained, and so the impact on credit total returns will be somewhat limited.
Consistent with this forecast, about 40% of Barings multi-asset portfolio is currently positioned in credit particularly emerging market US dollar denominated debt.
“Currently, debt accounts for 40% and EM dollar debt accounts for 20% of the portfolio. Both did grow substantially over the last two years," Mahon says.
In local currency terms, European high yield bonds will likely underperform their US counterparts, but shorter-term considerations, such as currency hedge costs, will come into sharper relief to investors looking to allocate to the asset class in the interim periods.
In equities, the UK have the highest return potential from a combination of low valuation and high dividend payout. US equities, on the other hand, have the lowest return potential with valuations remain at lofty levels, such that long-term investors may be left disappointed.
“Since we last ran our forecasts in 2018, equity market valuation multiples have fallen, and as such markets should fare slightly better than we predicted last year. Globally, equity returns of just about 5% per annum are realistic, but this headline figure masks the underlying trend,” Mahon says.
From today’s valuations, US equities are likely to struggle to match the returns investors have been used to. Global non-US equities are likely to perform moderately well, but even then, the returns are likely to be some way below the high single-digit annual return that so many investors require.
Consensus estimates of economic growth are too low. Although demographics will be a headwind, Mahon says that real economic growth will remain decent—though far from stellar. Inflation looks to be structurally lower than in previous cycles though.