As investors have come to understand, this is not a normal late-cycle environment. The late-cycle exuberance that is typically evident in risky assets is notable by its absence, while bubbles appear to have formed in safe assets.
Tight labor markets and flat yield curves are characteristic of late cycles, but other typical late-cycle phenomena — excessive risk appetite, tightness in basic resources and constraints on capital availability — have not materialized. We therefore need to recalibrate our thinking about late-cycle investing. In particular, investors need to focus on the challenges to portfolio construction that zero or negative bond yields present.
Against this backdrop, we are launching our 2020 long-term capital market assumptions. The assumptions provide capital market return estimates for more than 50 asset and strategy classes, examining how some of the structural factors affecting economies today are likely to drive asset returns over a 10- to 15-year investment horizon. Our forecast anticipates modest global growth and contained inflation. Growth remains low by historical standards, with aging populations a key headwind, while a technology-driven boost to productivity presents the main upside risk.
In many ways, the legacy of post-financial crisis monetary policy informs much of our outlook, and zero rate policy and quantitative easing may now be doing more harm than good. Still, given the growth environment, we would expect global monetary policy to remain extremely accommodative throughout this cycle and well into the next one.
This leads us to build a significant delay in interest rate normalization into our forecasts. That, in combination with much lower starting yields and only a modest cut to our equilibrium yield estimates, adds up to a sharp fall in projected fixed-income returns — in some cases taking them negative over our forecast horizon.
The sobering reality of negative yields is causing investors to rethink the concept of "safe havens" in their portfolios. With yields now negative on about 25% of government bonds globally, the ability to insulate a portfolio with bonds and clip a coupon is compromised. Indeed, we have now entered a world in which the trade-off in portfolio construction is no longer between forgone risky asset returns and reduced portfolio risk, but instead between a zero or even negative return in exchange for that risk reduction.
In our outlook, expected returns for a 60/40 U.S. stock-bond portfolio fall 10 basis points to 5.4% and the stock-bond frontier steepens a little. While the outlook for returns from government bonds are bleak compared with stocks, in the wider fixed-income complex, credit continues to offer a meaningful return uplift.
Equity forecasts improve as valuation and margin headwinds recede. Our average global equity return forecasts rise 50 basis points to 6.5% in U.S. dollar terms. Investors should bear in mind, however, that while equities are expected to deliver higher returns than bonds over the long run, in an economic downturn they will bear the brunt of market volatility.
Emerging market equity forecasts continue to offer the prospect of higher returns than their developed market peers but the emerging markets narrative is subtly shifting to one more focused on domestic growth from being a proxy for global trade. China, in particular, will provide a new set of investment opportunities as its pattern of growth develops and its asset markets open up.
Those seeking higher returns will continue to be drawn to private markets, where we expect alpha trends for financial alternatives to be steady, and more concentrated exposure to the tech supercycle is possible. Elsewhere in alternatives, real assets remain an attractive source of both returns and diversification.
Despite our expectations of modest global growth and modest returns, on average, over the next 10 to 15 years, we see some upside risks to our outlook over the medium term. The main upside risk is a technology-driven boost to productivity. Fiscal stimulus, which we expect will be part of the policy response to the next recession, presents another upside risk. Applied appropriately, fiscal stimulus may provide a route toward more normal levels of inflation and policy rates in the longer run, but its side effects are untested.
Above all, the zero or negative yields available in government bonds present a direct challenge for portfolio construction. There is a clear tension between the long-term effects of ultra-low rates that lead to a steep stock-bond frontier in which equity is clearly favored; and the short-term effects where absolute returns are subdued for most assets, as is characteristic of a late-cycle economy. Moreover, the low level of returns expected from bonds requires that we re-evaluate the role the individual investing building blocks play in constructing a robust portfolio. In sum, we need to reconfigure our portfolio design now that bonds simply can't offer the same combination of portfolio protection and positive income that they did in the past.
Despite these challenges, we are optimistic that with a little more flexibility in portfolio strategy, and a little more precision in executing that strategy, there are still reasonable returns to be harvested across the asset markets.
John Bilton is head of global multiasset solutions at J.P. Morgan Asset Management, London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.
