What a difference a year makes. At the start of 2022, the US S&P 500 index was trading at 22x forward earnings, 10-year Treasury yields were 1.5%, and the federal funds rate was at 0.0-0.25%. High valuations meant expected long-term returns for many assets were low: just 4.8% for US equities and 1.3% for Treasuries.
Today (at the end of February 2023), the S&P 500 price-earnings (P/E) ratio has dropped to 18x, Treasury yields are 200 basis points (bp) higher, and the fed funds rate is now at 4.50-4.75%. As a result, expected returns have improved dramatically — to 8.5% for equities and 4.9% for government bonds (see Exhibit 1).
2022 was about valuations, 2023 will be about growth
If 2022 was all about valuations, the issue today is growth. High post- pandemic inflation is decelerating, but there is still a debate about whether recession will ultimately be required to get inflation back to central bank targets, or whether this can happen painlessly via a ‘soft landing’.
The answer depends on where one looks. The US 2–10-year yield curve had been inverted since last summer and the German curve since last autumn. Consensus estimates called for a US recession this year. Many surveys of sentiment among CEOs investors showed similar expectations.
Equity and high-yield bond markets, however, now seem to reflect the view that recession will either be avoided, or if it occurs, it will be mild. Currently low end-2023 inflation expectations could discount the impact of recession, or the scenario that inflation will ultimately prove largely transitory and will continue to rapidly decelerate (in which case, the recession signal from the inverted yield curve would have been a false alarm).
We believe tight labour markets mean that recession in the US and sub-trend growth in the eurozone will be required to achieve central bank objectives for inflation.
Regardless of the near-term outlook, the inflationary impulse of the pandemic has at least returned long-term expectations to pre-Global Financial Crisis (GFC) levels (see Exhibit 2).
Stagnation, stagflation, soft landing?
Before the pandemic, secular stagnation was a popular view among economists. The idea (originally proposed by Alvin Hansen in the 1930s, but re-popularised by Larry Summers), is that there is a rising desire to save, but a declining desire to invest. This combination leads to under-consumption and investment, alongside lower growth, inflation and real interest rates.
The drivers for higher savings include income inequality and uncertainty over having sufficient income in retirement. Reduced investment is a function of stagnating labour forces, cheap capital goods (particularly since China has become integrated into the global economy), and the IT revolution, as tech companies tend to preserve capital.
Will secular stagnation remain the dominant economic trend? Labour market headwinds have been exacerbated by the pandemic as participation rates have fallen. Goods prices have risen due to supply chain bottlenecks, while plans to re-shore production should also lead to higher prices.
Additional – demographic – factors could be inflationary. Ageing populations may lead to less savings as the retired spend down their wealth. A smaller labour force should sustain wage gains.
While we believe the likelihood of higher inflation has increased, it is not our base case. Persistent worries about having sufficient income in retirement due to unsustainable pay-as-you-go systems and rising dependency ratios will lead to higher savings.
Moreover, money saved for retirement is often concentrated among wealthy retirees who have a lower propensity to consume. At the same time, we believe technological developments will continue to reduce the need for large-scale investments.
Climate change has become a much more salient issue. Ensuring a rise in global temperature aligned with the Paris Agreement will require a massive economic transition – and massive investment.
If well managed, such investments would predominantly replace existing ones in fossil fuels. The current level of investment in fossil fuels needs to fall. The danger is that ongoing investments could result in stranded assets as more stringent policies to limit global warming are implemented.
The need to invest instead in clean energy may well push up inflation and bond yields. For now, our base case is that climate change will increase uncertainty over nominal yields and inflation, but it does not impact on our long-term inflation and yield expectations.
Our current expectations for risk-adjusted returns for a euro-based investor are modest. Few of the assets shown in Exhibit 3 have a Sharpe ratio greater than 0.5.
We see better risk-adjusted returns for equities in the decade ahead than for fixed income, even though expected returns on bonds improved substantially over the last year. The large hedging costs for US Treasuries reduce the expected return, whereas in relative terms hedging costs have less impact on the expected equity returns.
Within core assets, we see credit outperforming government debt and equity, though there is little difference between investment-grade and high-yield corporate bonds.
For government bonds, we are modestly more positive on inflation-linked bonds than nominal bonds.
For riskier fixed income investments, we are comparatively positive on high-yield versus emerging market credit.
Within equities, we see more potential in Japan and emerging markets than in the US or Europe.
Finally, choosing between equity and listed real estate, we prefer equity.