From a macroeconomic perspective, one thing seems clear: monetary policy in major developed economies has come close to running its course. The fact that growth and inflation expectations reflected in government bond yields across the developed world remain so muted despite such a sustained period of low rates and quantitative easing, tells its own story about the waning effectiveness of monetary policy in the wake of the financial crisis.
A change in the overall policy mix is, in our view, necessary and inevitable, with the case for a step change in government spending to work alongside monetary policy intensifying. Given the potential for tax and debt-funded higher fiscal spending to also address widely-held concerns about social inequality, underinvested infrastructure and underfunded public services, we do not expect many major elected officials in larger developed economies to ignore the call for increased fiscal spending as the 2020s progress.
This policy evolution has potentially significant implications for capital markets. The broader risk and returns environment is likely to evolve into something strikingly different to the low volatility, strongly negative equity/bond correlation and high risk asset returns regime that investors have enjoyed for the majority of the past decade.
Indeed, the valuation starting point and prospects for higher volatility suggest risk-adjusted returns will be significantly lower in the 2020s for the majority of major traditional asset classes. Given the very low and negative yields in major government bond markets, this is particularly the case for fixed income; there is the very real prospect of negative returns for developed world government bonds for 'buy and hold' investors.
What should multi asset investors do? This decade-ending issue of Macro Quarterly explores our view of the 2020s policy outlook, its implications for markets and for the optimal strategic asset allocation of multi asset portfolios.
"If you don't know where you've come from, you don't know where you're going." Maya Angelou.
The 2010s: buy everything
To understand the likely paths of macroeconomics and capital markets in the coming decade, it is worth reminding ourselves where we start from. In particular, it is worth remembering just how remarkable the past decade has been.
Exhibit 1: Asset Class Returns in the 2010s
Following on from the 2000s, a decade book-ended by the dot-com crash and the 2008/9 financial crisis, high returns (excepting commodities) and low volatility have been the defining characteristics of the 2010s across asset classes amidst an increasingly consensual 'lower for longer' narrative.
Exhibit 2: Risk-adjusted returns were high in the 2010s
Major asset class 10yr Sharpe Ratio vs. history
The principal driver to the reflation of financial assets has, of course, been monetary policy. It was, after all, an explicit goal of monetary policy in the wake of the 2008/9 financial crisis to boost the US economy via the portfolio rebalancing effect. But even as the impact of low policy rates and central bank quantitative easing on the real economy has diminished, the policy stimulus and forward guidance provided by central banks have supported asset prices while suppressing volatility.
Exhibit 3: US equities outperformed in the 2010s
The combination of high returns, low volatility and a negative correlation between developed world equities and developed world government bonds has clearly aided the risk-adjusted returns potential of multi asset portfolios.
The same forces have prompted the shift from active to passive – a key feature of the 2010s – as the case for active has been diminished by the high beta component of returns.
Exhibit 4: Growth stocks benefited disproportionately from low rates in the last 10 years
At a more granular level, buying American assets (and, connectedly, buying 'growth' equities over 'value' in an environment where low rates have had a significantly greater benefit on the valuation of longer-term growth cash flows) has also been a defining feature of the 2010s.
But the most persistent theme over the past two decades - indeed, the most consistent theme over the past 40 years – has been the containment of inflation and the fall in nominal government bond yields across the developed world.
Exhibit 5: US Treasury 10y yields have been trending down for 40 years
We have written on a number of occasions about the structural decline in productivity, inflation expectations and population growth, plus the growth in demand for income from ageing populations and excess savings, and the role that all of these factors have played in suppressing yields alongside quantitative easing. Are these forces going to continue to weigh on the world's discount rate, the US 10y treasury yield, in the 2020s?
Policy in the 2020s
Our view is that we will not see a global recession in 2020. But whenever the next recession does arrive in the coming decade, neither the US Federal Reserve (the Fed) nor other major central banks appear to have sufficient room to ease policy rates enough to reinvigorate growth and inflation.
In previous cycles going back to the 1950s, the Fed's response to a collapse in demand has been to cut the Federal Funds rate by an average of 550 basis points. At the time of writing, the Fed has room for only another 175 basis points of cuts, having publicly stated its opposition to moving below the zero lower bound and into negative interest rates.
Exhibit 6: Running out of room? Fed has cut an average 550bp in recessions historically
In the Eurozone, Japan and Switzerland, policy rates are already negative, giving respective central banks next to no ammunition in the next downturn via the policy rates channel. Quantitative Easing (QE) could be increased again, but like official policy rates, the impact of QE on the real economy and on asset prices has diminished over time. This leaves major central bankers with a limited and increasingly ineffective toolkit with which to address the next recession.
So when the next downturn does come, we do not believe that monetary policy in isolation will be able to perform its usual counter cyclical role. Instead, we see the burden of providing the major stimulus to demand and inflation landing on government spending. Elected officials will therefore face a stark choice: let the economy stagnate, or spend. Given the very obvious electoral benefit incentive, we don't believe that many senior politicians will deliberate very long before embracing the fiscal mantra.
But there is more to the fiscal story than political expediency. In our view, the social and economic arguments for fiscal policy playing a significantly greater role in the overall policy mix in the 2020s are strong. We believe that current low borrowing costs provide further momentum. Indeed, with the cost of borrowing below current growth rates in major economies, it is theoretically possible for governments to borrow to fund fiscal stimulus and to address social imbalances without increasing overall net budget deficits. We also sympathize with the view that any fiscal multiplier (the benefit to the economy for every USD of government spending) may be greatest precisely at the point where monetary policy stimulus is at its least effective. If we are not already at that point, we do not believe that it is very far away.
If the arguments appear compelling, there are still hurdles to overcome. The blurring of the lines between elected officials and central bankers is far from straightforward and, at first glance, appears unlikely to evolve swiftly. We would highlight Germany in particular as a country with the scope for a significant fiscal stimulus to boost growth, but with little apparent political will currently to counter the balanced budget requirement enshrined in German law to progress such a move.
But the political backdrop can also change quickly. The pressure on governments including the UK, Germany, Japan and elsewhere to borrow and spend more is increasing - witness the promises of the major parties ahead of the UK general election. The finer details of a significant fiscal package are expected in the coming months in Japan where the government is already seeking to spend its way to higher growth.
Our conclusion then on government spending is more general than specific in nature: even if a major increase in fiscal spending isn't necessarily imminent across all major economies, the direction of travel for the coming decade seems very clear indeed.
More fiscal likely to push yields higher
The shift from monetary policy to fiscal policy could have a significant impact on asset prices and volatility. Increased monetary stimulus over the past decade has lowered interest rates across the yield curve – directly at the short end through the official policy rate and across the curve through QE, indirectly through forward guidance.
Exhibit 7: Higher fiscal = higher nominal GDP and 10y Yields
All things equal, we believe that increased fiscal stimulus is likely to increase interest rates across the curve as economic growth and inflation expectations increase, and likely at the long end due to an increased supply of debt.
But a key question about the impact of increased fiscal spending on yield curves is how central banks will react to the shift in overall policy dynamics. Will they continue to keep interest rates suppressed even in the face of rising growth and inflation expectations in order to steepen the yield curve, benefit banks and supercharge the growth outlook – or will they raise rates as growth and inflation momentum accelerates to allow more room to cut in the next downturn?
All the recent rhetoric suggests strongly to us that major central banks in the developed world are much more likely to let growth and inflation 'run hot' over time before hiking rates. This is a key reason why we believe developed world yield curves will steepen in the coming years.
As confident as we are in the increasing role of fiscal policy, there are other reasons to believe that the era of very low inflation may be coming to an end. The defining story of markets in 2019 has been the impact of geopolitics. The long-term trend of globalization and the removal of barriers to trade has been a key downward force on global prices in the last few decades. The recent rise of economic nationalism, itself a consequence of many of the same pressures that we expect to drive an increase in fiscal spending, is now prompting globalization to slow.
Exhibit 8: Rising geopolitical risks
Global Economic Policy Uncertainty Index (Current Price GDP Weights)
And like fiscal spending, we do not see the forces behind protectionism abating anytime soon. By way of example, it seems clear that the US/China conflict isn't just about trade, but about ideology, technological superiority, strategic competition in regional spheres and capital flows. None of these issues appears likely to be resolved quickly.
What does all this mean for markets in the 2020s?
To cap off what had already been a strong decade, 2019 has seen an aggressive rally in fixed income, the closing of credit spreads and a rerating in global equities as the monetary policy stance has undergone a dramatic pivot. The 'lower for longer' narrative has returned.
We believe that index returns are likely to be lower in the coming decade across traditional asset classes in the 2020s, particularly in fixed income. The 10-year annualized return forecasts from our Strategic Asset Allocation team for selected asset classes are set out below.
Exhibit 9: Returns are likely to be lower across asset classes in the 2020s, particularly in fixed income
10yr forecast returns vs. past 10yr actual returns
More than anything the outlook for lower returns reflects the valuation starting point across asset classes relative to history. But for US equities in particular there are potentially other pressures than the valuation multiple investors are willing to pay for US corporate profits. Remarkably little of the outsized US equity returns of the past decade can be attributed to an expansion of PE multiples. Despite mediocre to lackluster US demand growth, by far the biggest contributor to US equity returns has been earnings, which have grown at a compound annual rate of over 12% over the past decade vs. US GDP growth of around 2.5% per annum, according to data provided by Refinitiv. In our view, that profits growth has been so strong relative to real economy measures is ultimately unsustainable; profits and demand growth are inextricably linked over the long term. Indeed, that such a large share of US GDP should go to shareholders at the expense of labor is part of the social argument for higher fiscal spending.
In the past, quasi-monopolistic profits have either been competed or regulated away. We see increased regulation or a change in tax and accounting rules impairing US corporate profitability in the 2020s in a bid to address some stark imbalances.
Exhibit 10: Corporate profitability expanding at the expense of labor
In our view, the valuation of US equities in particular limits the potential upside for the 2020s. Professor Robert Shiller's widely-watched cyclically adjusted Price to Earnings ratio, which has shown a statistically strong relationship with subsequent 10 year returns in the past, also points to lower returns in the 2020s.
After a sustained period of very low volatility, we also expect overall asset class volatility to edge higher in the 2020s to reflect continued geopolitical risks, the shift in the policy narrative from unelected central bankers to electorally sensitive politicians, and the gradual increase in inflation expectations and longer-dated yields as fiscal policy goes to work.
It is therefore on a risk-adjusted basis that, to us, US equities look most stretched relative to history. And after a decade of US outperformance driven in part by the boost from low rates to 'growth' equity valuations, we therefore expect more 'value'-oriented equity markets outside of the US, such as Europe, Japan, China and emerging markets, to prosper on a relative basis as yields rise.
Higher correlation between equities and bonds
So what can individuals and institutions do to meet return targets in this environment? If the overall returns environment is lower, it is self-evident that investors are going to have to take more risk to achieve the same returns.
The correlations between asset classes are the statistical bedrock to the principle of multi asset diversification and to improved risk-adjusted returns potential. But portfolio risk itself is not a constant. And the strongly negative correlation between US equities and US Treasuries over the past 20 years that has given investors such simple diversification benefits has been abnormal in a longer-term context.
Exhibit 11: Strong equity returns unlikely to persist
Shiller cyclically adjusted earnings yield vs. subsequent 10yr US equity returns
Exhibit 12: Shiller cyclically adjusted earnings yield vs. forward 10yr US equity returns 1973-2009
In a previous paper (Investment Insights, Relationship Troubles, Feb 2018) we highlighted how the inflation backdrop – both the absolute level of inflation and the volatility of inflation – was the principal driver to the equity/bond relationship. We were able to identify four distinct inflation regimes over the past 90 years.
Given our core belief that increased fiscal spending will reinvigorate growth and inflation in the developed world in the 2020s, we expect the key correlation between US equities and government bonds to become less negative as the 2020s progress. We also see the range of potential macroeconomic scenarios broadening from the narrow range of the past decade. There is therefore a risk that any spike in the level and volatility of inflation could prompt the equity/bond correlation into meaningfully positive territory again.
Exhibit 13: US equity/bond rolling 3yr correlation 1963-2019 vs. Inflation
A second act for bonds
Clearly, any regime change in correlations has potentially significant implications for the risk-adjusted returns potential of the wall of money invested in multi asset portfolios predicated on a significantly negative correlation between these two key asset classes.
Indeed, there has been a host of recent commentary seeking to address this issue, some of it even sounding the death knell for the traditional 60:40 equity/bond multi asset portfolio. We agree that after a decade of outsized capital growth and low volatility that the outlook for risk-adjusted returns in global equities and in developed world government bonds is commensurately lower.
But while the outlook for capital growth in nominal government bonds in the 2020s looks limited given the yield starting point, that is not to say that bonds do not still have an important role to play in a multi asset portfolio context as a potential store of value. Our work shows that bonds have generally (but not always) provided important diversification benefits during large equity drawdowns even in positive equity/bond correlation regimes. We also believe that there are likely to be a growing array of tactical opportunities both within and across yield curves on a relative basis globally in a more volatile market backdrop.
Overall, we see the prospect of lower risk-adjusted returns and higher equity/bond correlations strengthening rather than weakening the arguments for multi asset portfolios. But genuine diversification is about differing macroeconomic sensitivity, not about an arbitrary number of asset classes. The anticipated combination of lower returns and higher volatility also suggests strongly that a more careful and potentially sophisticated approach to portfolio diversification and optimization is going to be required than has been the case for the past decade. In short, we see investors needing a broader investment universe of traditional and alternative asset classes diversified by macroeconomic driver.
This potentially includes a strategic allocation to inflation-linked government bonds and to currency, and to real assets including gold and real estate that might benefit from higher inflation. We would also highlight infrastructure. The increase in fiscal spending that we expect is likely to mean a growing global opportunity set across economic and social infrastructure assets in both the developed and emerging worlds, that may offer stable and attractive cash flows to investors across the capital structure.
In our view, buy and hold is likely to be a sub-optimal strategy in the 2020s. We see both tactical and secular active manager skill, or alpha, contributing much more significantly to overall returns than it has done overall in the past decade. High conviction active approaches across private and public markets are likely to prosper in a more volatile and challenging environment.
Incorporating alternative sources of alpha from advanced sentiment models, big data, as well as the ability to exploit the increase in tactical opportunities we expect are also likely to play a major role in improving the risk-adjusted returns' potential of any multi asset portfolio.
In our view, access to the broadest possible tool set to implement views in an optimal manner is also likely to be critical to overall risk-adjusted returns in the coming decade. This includes, where appropriate to the mandate, incorporating non-linear pay off structures to generate income, and to both benefit from and protect from the more volatile backdrop we expect.
The asset allocation outlook for the coming decade may appear challenging at first glance given the headline forecasts of lower returns, higher volatility and higher correlation from equities and government bonds. But there is little doubt in our mind that it will be a period rich in potential for those with the tools and expertise to exploit the opportunities that may arise across the full universe of traditional and alternative asset classes.
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