What are the long-term expected returns for the different asset classes?
More than ever, asset allocation depends on the risk-return trade-off.
IN A WORD:
More than ever, asset allocation depends on the risk-return trade-off. COVID-19 has been a game changer and will lead to low rates and yields for quite a long time. Guidance from central banks also points in that direction. It also implies lower expected returns on many fixed-income assets over our 10-year forecast horizon. Risk premiums are expected to be broadly in line with historical averages. There have also been some structural effects on employment markets that will take quite some time to normalize and this should lead to lower economic growth on average over the period. This has led us to revise our growth rates for dividends and/or the potential for so-called re-rating effects (higher Price-to-earnings ratios). Consequently expected returns for equity markets have been revised down.
It is the first time in history that expected returns have been so low, especially in real terms, as inflation should remain positive in both the United States and Europe.
Investors have two options today:
- Either to prefer a low-risk long-term return that is below inflation in the fixed-income investment universe,
- Or to take on more risk and allocate more to equities and alternative investments in the broader sense.
Our strategic asset allocation decisions continue to favour:
- long-term investments (increased duration)
- assets with a higher risk return profile (equity markets and real assets, such as real estate, commodities, etc.).
Comparison of long-term expected returns in 2020 vs 2019 and 2015
Conclusions from these three charts:
1) The first remark is visual: expected returns are more ‘out of step’ in 2020 than in 2019 and 2015, moving away from the regression line.
2) The decline in yields in the bond universe has continued and has led to an average downward revision of -0.5% for the expected returns of fixed-income assets. The fall in US dollar yields over recent months has been somewhat larger than for euro-denominated bonds. The revisions in expected returns for USD- denominated fixed-income assets are thus somewhat bigger.
3) Expected returns on equity investments are around -0.75% lower today than they were in our exercise last year. That is linked to lower dividend yields, dividend growth and/or less potential for re-rating.
4) To adapt to this environment, investors should focus mainly on the long term and should:
- extend the horizon of their investments;
- accept more risk in their investments in fixed-income assets (Corporate bonds while remaining diversified);
- increase the pocket of equity markets which generate higher dividends than bond yields; and
- diversify into real and alternative assets.
We recommend keeping a long-term strategy that works well: take advantage of price declines when they occur, in order to strengthen investments in risky assets.
This helps to make the link between the long-term view explained in this paper and the more practical decisions which must be taken on a daily basis.