Silver Linings in the New World

It might not feel like it, but the investing environment is better now than two years ago. Specifically, it’s a better entry point for long-term investors — for two reasons:

• expected returns are higher across almost all asset classes
• better returns are on offer in some less risky asset classes (cash, credit and bonds)

In the current market, most investors can generate more return by taking on less risk.

Based on our expectations for annual average returns for each asset class over the next decade, we expect an investor entering the market today with a ‘balanced’ portfolio to average returns of around 7.2% per annum. This estimate is about 1.5% higher than an investor entering the market two years ago.

The chart below summarises these findings.

The asset classes linked to interest rates show the most significant change.

Expected returns on cash have jumped from 1% to 3%, government bonds from 1% to nearly 4% and credit from 2.5% to 6%.

Credit offers a range of opportunities. US investment grade is currently around a 5% return but is likely to rise further as the Fed continues to raise rates. High-yield and emerging market debt are also promising, varying between 6% to 10%. As interest rate securities typically represent around 30% of a balanced portfolio, these changes most significantly boost the projected returns.

Equity markets currently have higher returns because of the lower starting point for valuations. Critically, the price you pay determines the future return for equities. And valuations are much lower than at the market’s peak in 2021.

An important consequence of a lower starting valuation is a change in the risk-reward ratio. Ultra-low interest rates forced defensive investors to take on more risk because the return on many ‘safe’ assets fell below the inflation rate.

Bonds and cash holders were likely to see the real value of portfolios decline. But this is no longer the case — investors can make far better returns without too much risk. The expected return on defensive portfolios has increased the most of all the risk profiles — by around 2.3% to 5.7%. And at that level, it represents a reasonable real return for investments. This compares with the return on ‘growth’ portfolios that have risen from 1.6% to 8%.

Investors often ask us whether the higher inflation rate will make it harder to achieve benchmarks expressed relative to the inflation rate. My view is the central banks will eventually get inflation under control — and the long-term average inflation rate will only be slightly higher than before — around 2.5% to 3% in the future compared with 2% to 2.5% in the past.

Since our expected returns have increased more (1.6% to 2.3%, depending on the risk profile), we’d argue that existing CPI plus benchmarks should be easier, not harder, to achieve.

Current recommendations

There are plenty of opportunities for investors now, particularly in interest rate securities and infrastructure:

• Interest rate securities: we prefer floating rate, investment grade and private credit, with a range of options with yields from 6% to 8%.

• Unlisted infrastructure: there’s an opportunity, given the potential to return 8% to 10% per annum over the next few years.

In equities, we’re more selective (for now):

• We’d hold off from adding broad market exposure in equities. Our strongest recommendations are in Chinese H shares, Commodities and Small Cap companies in the US and Australia.