The investment industry reminds clients that past performance is no guarantee of future returns. This standard disclaimer looks particularly foreboding at the moment for investors facing a world of high bond prices and lofty valuations for tech and quality companies that dominate US and other equity markets.
Such a starting point for the two leading asset classes — publicly traded equities and bonds — means a tougher future lies ahead. Various asset managers are expecting a middling single-digit performance over the next five years. That will look a lot worse in the event of a more inflationary environment.
Traditional investors face a two-fold problem. Further capital appreciation in equities and bonds appears limited by their current high prices. True, some pockets of the equity market away from the fast-growing tech companies appear to offer some relative bargains. But they are cheap for a reason, given disruptive forces that will probably prevail even when the pandemic abates or a vaccine arrives.
As for sources of income that are reinvested over time, not only are global government bond yields near zero, but fixed returns for highly rated corporate debt are also shrinking. For example, Citi Private Bank estimates that the global bond market now yields 1 per cent, even including high-yield and emerging markets. Even for equities, the blue-chip S&P 500 index’s 12-month trailing dividend yield sits at 1.86 per cent and has spent the past decade around 2 per cent.
A tech-led pullback in equities has resulted in Wall Street falling at around double the pace of global rivals during September. But what stands out at the moment is the lack of an appreciable rally in the value of 10-year Treasury notes. Normally, declining equity prices are accompanied by Treasuries appreciating sharply in value, reflecting their haven status within a broad portfolio. Instead, Treasuries have been range bound since early August and a 10-year yield stuck around 0.66 per cent suggests limited capacity for significant gains that can help offset the portfolio pain from a tumble in risk assets.
Hence concerns over the viability of the storied 60/40 portfolio mix and why some investors advocate pushing harder into equities at the expense of holding Treasury bonds that behave more as a cash instrument. Others look at higher-yielding corporate bonds, now backed by central banks, as potentially replacing the role of government debt in portfolios.
The question, then, is whether to look further afield. During the past decade, investors have increasingly sought out less liquid areas, including real estate, infrastructure and privately traded assets for returns that are relatively isolated from swings in the value of publicly traded equities and bonds.
Expect a bigger push into these so-called alternatives, particularly given the worrying dynamic playing out between equity and bond markets during the current bout of risk aversion.
Mark Haefele, chief investment officer of global wealth management at UBS Wealth, is among advocates of diversifying portfolios through private markets. He argues they can enhance returns for investors, given how the pandemic chimes with the economic and market dislocations of 2001 and 2008. “The asset class typically generates higher returns than listed markets given its ability to earn an illiquidity premium of around 1 to 3 percentage points a year.”
In real estate, for example, Citi Private Bank believe cell towers, industrial Reits and healthcare facilities may benefit from increased spending on infrastructure or healthcare.
Pouring some cold water on the matter, analysts at Bernstein highlight that “historically high levels” of private capital cash may well push up the entry price of assets and, in turn, ultimately reduce long-term returns for investors. The amount held in private equity, real estate, infrastructure, private debt and natural resources has climbed to $2.5tn from $2.3tn this year, according to data provider Prequin.
Another concern is that a nasty bankruptcy cycle will impair private equity performance, particularly in areas of commercial real estate. Investors also face a lottery in terms of performance from a sector that is not shy about charging chunky fees that erode returns.
More money will probably flow into alternative assets, but the much smaller size of this market, compared to public markets, likely limits just how far such an approach can shift the needle for stronger long term performance. Returns from private assets will help, but ultimately, a broader approach remains important: one that seeks streams of dividends and coupons in equities and areas of structured credit that are less influenced by sudden changes in market interest rates.
Welcome to the challenging times of low rates and high valuations.