A catalyst for diversification

 Five-year capital market assumptions

Preparing for lower expected returns

Risk asset performance has exceeded even our optimistic scenarios over the last 8 months, but going forward, returns across equities and credit are sharply lower. Investors must consider diversifying into alternative assets to improve returns.

Highlights

  • The performance of risk assets since May exceeded even our optimistic return scenario.
  • Forward five-year returns across equities and credit are now sharply lower relative to six months ago.
  • Global equities are expensive on an absolute basis, but fairly valued relative to bonds and cash rates.
  • We expect the US dollar to continue to weaken. In general, US investors should not hedge their international exposure, but foreign investors should hedge their exposure to USD denominated assets.
  • We believe that alternative assets are more attractive due to lower expected returns in public markets and are poised to improve the risk/reward profile of balanced portfolios.

UBS Investment Solutions provides estimates of capital market returns across a wide array of asset classes and from multiple currency perspectives.1 For this paper, we focus on our 5-yr baseline expected geometric returns.

Our last publication highlighted our May 2020 assumptions amid significant uncertainty due to first few months of the pandemic and the upcoming US elections. We used scenario analysis to explore our Base, Bull and Bear cases for the markets. Even as the public health crisis rages on, the equity market staged a recovery beyond what we forecasted in our optimistic scenario for the next 6 months. Another recent positive is the resolution of the US elections reducing policy uncertainty and tail risks.

These positives have been reflected in the recent strong price performance of global risk assets. As such, they come at a cost: financial asset appreciation has been pulled forward, and the outlook for forward returns is meaningfully reduced relative to six, or even two, months ago.

The main updates in our five-year capital market assumptions compared to our May 20202 report are:

  • Equity returns in nominal terms are sharply lower—1.0 percentage point lower. We expect a global equity portfolio to return 6.5% annualized in unhedged USD terms over the next five years. The main cause is the huge run-up in the equity market: the MSCI ACWI has returned 27.6% since the end of April (and up close to 50% from its March lows).
  • The currency component of global equity returns has declined from 0.6% to 0.3%.

Current government bond yields — which are the primary determinate of expected return -- are about the same as in late spring. Government bond yields in the US and China have drifted higher, but European and emerging market yields declined, so the reaction in the markets has been mixed. Overall, the return to government bonds since our last report is about the same: -0.1% (hedged USD terms), unchanged from the May 2020 estimate.

  • Credit spreads have had a roller-coaster ride in 2020. They troughed in early January 2020 approaching extreme lows before surging in February and March to their highest levels since the Global Financial Crisis. As the equity markets boomed, credit spreads compressed substantially and are now below median levels of the last ten years.
  • The expected return for a global investment grade debt portfolio is 0.2% in hedged USD terms, a drop of 0.9 percentage points from our estimate in May.
  • The expected return for high yield bonds declined to 1.8%, a large drop from 4.1% in May.
  • In general, the dollar is down sharply since mid-year. The DXY index is down 6.9% from April to November. The dollar has declined 8.4% and 6.8% versus the Euro and Renminbi, respectively since April.

Return and risk assumptions: USD terms – November 2020

Asset Class

Asset Class

5-yr Expected Return

5-yr Expected Return

Economic Risk

Economic Risk

Appraised Volatility

Appraised Volatility

Asset Class

USD Cash

5-yr Expected Return

0.3%

Economic Risk

1.3%

Appraised Volatility

Asset Class

Global Investment Grade Fixed Income

5-yr Expected Return

0.0%

Economic Risk

5.5%

Appraised Volatility

Asset Class

Global Equities Unhedged

5-yr Expected Return

6.5%

Economic Risk

16.0%

Appraised Volatility

Asset Class

Global High Yield Hedged

5-yr Expected Return

1.8%

Economic Risk

10.5%

Appraised Volatility

Asset Class

Global Private Equity Unhedged

5-yr Expected Return

8.8%

Economic Risk

24.5%

Appraised Volatility

15.0%

Asset Class

Global Infrastructure (Equity) Unhedged

5-yr Expected Return

5.5%

Economic Risk

14.0%

Appraised Volatility

8.0%

Asset Class

Global Core Real Estate Unhedged

5-yr Expected Return

5.2%

Economic Risk

12.6%

Appraised Volatility

7.2%

Asset Class

Hedge Funds (Hedged)

5-yr Expected Return

4.0%

Economic Risk

4.3%

Appraised Volatility

Part II: The prospects for alternatives

Alternative investments are becoming a larger and larger component of investors’ portfolios. The Yale University endowment – which pioneered heavy alternative investments – is now up to 75% alternatives. Alternative investments have backed their reputation with strong historic performance.

One attraction for alternative investments is the lower expected returns in the public markets. Cash rates are near zero or negative for most countries and the long end of many yield curves are still near historic lows. With such low rates and expanding equity valuations, investors will continue to turn to alternatives to improve portfolio performance.

The key point of alternatives is their ability to improve an investor’s return/risk profile. One, private equity, offers the ability to improve return; the rest – real estate, hedge funds, infrastructure – offer the ability to diversify and lower risk of the portfolio for the same level of return. (Of course, individual funds can do as well as equities, but we are considering what well-diversified portfolios should return. More concentrated and focused funds can offer returns in any environment.)

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