BLOG: Which asset classes should long-term investors focus on?

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The Covid pandemic, inflation and war have created a difficult start to 2022. For long-term investors, where can they look for returns?

The unique situation created by the Covid-19 pandemic means that we have experienced in just a few years an economic cycle of recession and recovery which should normally last much longer.

Inflation is at its highest level in thirty years and is not expected to fall again until 2024. The shocking humanitarian crisis unfolding in Ukraine is also having an economic impact by hampering economic growth and creating higher and more sustained inflation.

In this context, what are the long-term return prospects?

The chart below shows the expected ten-year annualized returns (as of April 2022):

Nominal government bonds

Starting yields are now much higher than a year ago, which means that global fixed income yields have improved slightly thanks to their carry component.

When the starting yield is low, investors are more likely to suffer capital losses as rates rise, not offset by a large coupon for the foreseeable future. We think central banks have generally left interest rate hikes a bit late and as a result we could see rate hikes continue beyond 2022 to bring inflation down.

Inflation-linked government bonds

The relative attractiveness of these bonds can be estimated through what is known as the equilibrium rate, ie the level of inflation that makes nominal bond yields equal to real yields. If the inflation achieved is above the break-even point, the yield of the index bond will be higher than that of the respective nominal bond. Since these instruments are correlated to inflation, “linkers”, as they are called, tend to offer less diversification compared to nominal bonds.

Rising nominal rates are inevitably bad for bond prices. However, the ability of linkers to outperform nominal values ​​depends entirely on the effectiveness of monetary policy in curbing these high levels of inflation. Given the evolution of monetary tightening expectations, we believe that investors are now even overestimating, in some cases, the extent of monetary tightening that will be necessary to bring inflation down. As a result, expected returns for linkers are now somewhat lower than face values ​​in this framework.

From a risk management perspective, it is important to consider the ability of these investments/assets to offer protection against sudden and unexpected price increases; giving up some of the return for greater protection might be a justifiable choice.

Emerging Markets Corporate Bonds and Sovereign Debt

As sovereign yields are up slightly, yields to maturity on risky bonds this year are higher than last year. Interest rates are still relatively low from a historical perspective, and as such, the risk-free component of government bonds clouds the long-term outlook for this asset class.

From a relative value perspective, we see a good risk-reward trade-off between emerging and global investment grade bonds versus global high yields, with the default rate implied by current spreads implying a much higher default rate. higher than the actual historical default rate for these securities.

Shares

As in previous years, equity valuations are relatively high, particularly in the US where multiples have continued to rise at a rapid pace, meaning US equities look particularly expensive.

UK and European equities look more attractive as they are closer to historic valuations – the UK in particular, which offers the highest historic dividend yield. Although Japan also looks cheap relative to the US, we assume weaker growth than the rest of the world, meaning it also points to a region of disappointing returns.

The expected return from emerging markets has improved from a year ago on the back of strong long-term earnings growth and, again, more favorable valuations relative to the US in particular.

Equities are also an asset class capable of protecting investors from long-term inflation. We believe it is an important part of the portfolio in addition to providing historically strong returns.

Merchandise

Commodities are a fairly volatile asset class, since the main world indices are mainly composed of energy, cereals and metals. Many of these products see their prices rise and fall due to imbalances in supply and demand that can be affected by monopoly decisions, regulation and harsh winter weather.

In recent years, commodities have underperformed other risky assets. However, thanks to Moneyfarm’s strategic asset allocation approach, which we undertake every year, we started to see positive signals at the end of 2020. 2020 and 2021 saw a huge rise in commodity prices in due to disruptions caused by Covid-19. With starting prices now much higher than in the past and inflation expected to normalize over the longer term, the expected long-term commodity return has fallen from our last December update.

In the long term, there are still challenges to overcome. The climate transition will affect investments in fossil fuel power plants, making energy inflation less predictable. Geopolitical tensions can affect Natural Gas, pressure on the demand for green transition materials can lead to shortages and finally more extreme climatic conditions can affect the equilibrium prices of cereals and energy.

All of these factors make the commodity basket a useful diversifier in multi-asset portfolios.

As always, we recommend a diversified portfolio to clients to offset some of the high risk/high reward allocations with more stable income streams. 2022 is shaping up to be a difficult year – with a series of geopolitical and macroeconomic challenges.

In this context, it is useful to remain focused on the long term. We see the greatest opportunity in equities and the stock market for our long-term outlook, particularly as a way to counter inflation. As the value of cash escalates, we expect more people to move their savings into investment vehicles.

Richard Flax is Chief Investment Officer at digital wealth manager Moneyfarm

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