Be aware of your assumptions

Since 2009, investors and markets have been highly sensitive to risk — and markets have offered high risk premiums. As these risks have gradually diminished, all asset classes have benefited. Equities have risen, bonds have rallied and, generally speaking, long-only investors have benefited. There's a strong case to be made that this cycle is at or nearing completion. The good news is that the U.S. economy is largely back on track and the global economy is improving.

There is, however, a divergence in monetary policy across the developed markets. The U.S. Federal Reserve and the Bank of England likely will raise interest rates and continue to do so over the next three years, while the European Central Bank and the Bank of Japan will extend accommodative monetary policies and we don't expect these central banks to start raising rates for some time.

With this backdrop, according to our latest 2015 long-term capital market assumptions, we believe that expected risk-adjusted returns will be lower than historical averages for most asset classes. In particular, public equities, which offered 11-year compound annualized returns of 8.8% from 2004 will return closer to 8% in the next 10 to 15 years.

Investors in search of higher nominal return opportunities will have to reach further afield, into emerging markets bonds and equities, and less liquid markets such as real assets, infrastructure, private equity and credit.

For fixed-income investors, government bonds and long-duration assets in general could see significant deterioration, requiring investors to seek regional diversification across bond markets and attractive sources of income to meet liabilities.

We have moved from the simple beta world where asset prices were consistently rising, to a more difficult alpha world where investors need to generate returns through active management and active allocation across asset classes, countries, sectors and companies.

Our return assumptions for 2015 include the following insights:

1. Economic growth has stabilized at mediocre levels — by historical standards — as the world economy continues its journey toward deleveraging and rebalancing.


2. Our economic assessment remains broadly unchanged across developed markets. By contrast, we have downgraded some assumptions across emerging markets, that face a less friendly global environment, coupled with domestic challenges.


3. Inflation remains benign, given still high levels of spare capacity globally for at least the next three to five years. Ultimately some governments might pursue policies to make inflation part of the solution by which fiscal solvency pressures are resolved.


4. Long-dated government bonds remain the “low Sharpe ratio” assets over the assumptions horizon, equities and credit should fare better given the more substantial risk premium.


5. We favor, less liquid markets where the risk premiums contraction has lagged, such as value-added real estate and private equity or direct or indirect leverage (through reduction of the bond allocation).


6. Hedge fund investments and regional diversification across bond markets remain attractive diversification opportunities for fixed income investors.

Investors should be aware of how the long-term direction of capital markets can affect investment outcomes. With the global economy entering a period of stabilization — while offering mediocre growth — it is an important year to revisit your base case and ensure you are prepared for what the next cycle may bring.

Jed Laskowitz is Chief Executive Officer, Asia Pacific and co-Head of Global Investment Management Solutions for J.P. Morgan Asset Management.