As the year enters its last stretch, it is customary to start analyzing the current environment in order to extrapolate longer term projections. In this light, in our last missives, we started looking at how current valuations and economic conditions might be affecting expectations and future asset allocations.
One interesting element of analysis in this process is the updating of long-term capital market assumptions. In this exercise, an analyst would tweak long term averages of returns as a function of current variables such as valuations, global macro data and expectations of productivity and come up with 10 to 15 years projections of annual returns.
JP Morgan has just put out their yearly update which reviews expected long term returns for different asset classes and for a hypothetical 60/40 portfolio (60% equities – 40% bonds).
The current mix of expected slow growth, flat productivity and high equity valuations produces a forecasted annualized rate of return for the stock-bond portfolio of 5.4% for the next 10 years. This is considerably lower than its historical average of approximately 8%. Interestingly, our financial planning algorithm uses similar projected values for our calculations.
On a relative basis, equities still look much more attractive than bonds as fixed income’s Sharpe ratios (a risk adjusted relative measure of performance) have continued to deteriorate. Conversely, emerging markets project better returns as general valuations are still more attractive than US equities. Emerging market bonds also show decent projected returns around 5.9% with a preference for local currency paper in light of a US Dollar that may start to weaken. Tactically, the issue with Emerging Markets is the short-term window where high correlation to trade volatility makes the asset class more uncertain. On a longer-term basis, however, the higher rates of growth of those economies should be reflected by higher equity and bond valuations.
There are a few elements that may cause a re-rating of these projections. One of them is a surge in productivity. Interestingly, productivity improvements have been elusive in this business cycle which was marked by deflationary forces rather than by growth resurgence. Looking forward, economists believe that automation and AI could potentially add 1 to 1.5% point to global trend growth. Admittedly, this call has gone unanswered for a while.
Another element that could skew long term assumptions is a shift from monetary policy to fiscal policy as a way to lift growth rates and reduce inequality. This strategic change could have major repercussions to different asset classes as inflationary pressures might once again start materializing. Such a factor would favor real assets, infrastructure investments and should extend the real estate cycle.
Overall, these projections show elements of caution and yet provide an overall long term positive outlook for diversified allocations.