For most of the last decade, we have based our long-term forecasts on the prospect of solid but sluggish growth, low inflation and low but ultimately rising interest rates. The chances of surging inflation or a deflationary slump appeared very low. But after Covid-19, these risks and their less extreme variants now look much more likely.
Note: 10Y refers to ten-year tenor
Source: SAA Team, Aberdeen Standard Investments, September 2020
We have set out six potential scenarios for the global economy in the coming decade, which we outline here. In this article, we look at what these scenarios mean for the main asset classes.
Government bonds: risk without returns
With current bond yields so low, the prospects for capital returns from government bonds do not look good, and the offsetting income is likely to be minimal. As yields increase during the next few years, we expect bonds to generate total-return losses. Thereafter, excess returns should remain low as the differences between bond yields and subsequent short-term rates are likely to be negligible. So long-dated bonds will not provide a much greater yield than cash, but will be considerably more volatile. They will, in other words, offer risk without returns.
The outlook for government bond returns is worst in Europe, where negative nominal yields offer the worst long-term value, and in the UK, where the longer maturity of bonds means more interest-rate sensitivity – and larger losses as yields rise.
Corporate bonds: slim but stable returns
In recent years, the strong performance of government bonds has turbo-charged returns from corporate bonds. But with government bond returns set to be lower, credit returns are likely to suffer accordingly. Government bonds have the biggest influence on investment-grade bonds (as the index has a longer maturity), so their returns are expected to be particularly low. The outlook is somewhat better for high-yield and emerging-market (EM) bonds, although returns may still be slim by historical standards. If market turbulence increases, however, we do think that corporate bonds will offer more stability than most other assets.
Equities: probably positive – but risks loom large
The economic environment for equities is benign in the base case, but challenging in other scenarios. We should see a return to solid earnings growth as we exit the Covid recession, but interest rates are set to remain near their all-time lows. This justifies high valuation multiples and attractive returns, particularly for markets with the highest growth, and for the UK and other markets that remain cheap. But if economic growth stagnates or, conversely, if unrestrained fiscal and monetary stimulus results in much higher inflation, equity returns would suffer severely. For now, however, the relatively low probability of these malign outcomes is more than offset by the higher probability of positive scenarios.
Real assets: infrastructure the standout
Alternative assets like infrastructure and real estate should benefit from the extremely low interest rates in our most probable scenarios. The long-duration cash flows of these assets are worth more in a world where risk-free rates hover around zero. However, real estate has suffered from the shift to online retail, which has accelerated during the Covid lockdown. There are also questions about how much the office segment will be permanently affected by Covid-driven changes to working patterns. On the other hand, sectors such as logistics distribution and housing offer a positive story.
Infrastructure is in a more unambiguously positive place, as it is likely to benefit from post-Covid stimulus. Its relatively low exposure to the business cycle and built-in inflation-protection make it one of the most consistently successful assets across the range of possible long-term scenarios.
EM debt: appealing prospects
Although inflation in EMs has moved down towards developed-market (DM) levels, real and nominal yields remain a little higher. Their attractions are not entirely offset by currency weakness. China’s resilience in the Covid crisis is supporting investor sentiment and economic activity in EMs, particularly in Asia. Any continued weakness in the dollar would underscore the opportunities here by supporting both EM currencies and commodity prices. If backed by strong US fiscal stimulus, it would also contribute to flows into EMs. So, as DM yields near zero, the EM sovereign market offers appealing prospects – though it is by no means defensive.
The old rules no longer hold
Across the range of potential scenarios, pickings from the broad asset universe look slim. Despite their high valuations, equities should offer strong returns in the most probable scenarios. But we expect government bonds to generate losses in the long term – greatly reducing their ability to offset falls in the stock market. Corporate bonds, which have traditionally offered a middle ground between equities and sovereign bonds, are likely to offer only meagre returns.
With traditional asset allocation compromised in this way, investors should look for a greater contribution from relative-value strategies, active management and astute stock selection. Amid the global uncertainties wrought by Covid, we can no longer rely on a one-size-fits-all approach to risk.
Read the next Global Outlook article Laying to rest the ghosts of inflation past.