About a year ago, when Alexandre Tavazzi, head of CIO office & macro research at Pictet Wealth Management, penned his annual prediction report for return expectations for the next 10 years, developed market treasuries, like German Bund and Japanese yen bonds, had had negative returns.
For the year 2022, he advised clients to replace part of their bond allocation with hedge funds, which played a role in downside mitigation as well as diversification in a portfolio.
The market backdrop has since drastically shifted. Borrowing rates are at a much higher level now. The U.S. Federal Reserve raised benchmark rates 10 times in a row to wrestle control of stubbornly high inflation. The higher interest rates do not only reward investors in their bank deposits but those allocating money to bonds . Tavazzi thinks this is where the opportunities are.
Better Returns in Quality Bonds
Higher interest rates mean expected returns for fixed-income assets have risen significantly. Improved short-term returns in the asset class also have driven investors back to the 60-40 portfolio, where 60% is invested in stocks and 40% in bonds.
“[The comeback of 60-40 portfolio] has been the case because bond yields have been moving higher,” says Tavazzi, who has also re-entered the credit market, but only in the high-quality investment grade area.
Explaining the zero exposure to high-yield bonds, Tavazzi does not think the risk of investing in high yield is appropriately compensated at this stage of the current economic cycle. He continues: “If you take into account the scenario that we have for this year, which basically is the U.S. economy falling into recession in the second half of the year. As we look at the next 12 months and compute the default and recovery rates, even if you get a decent yield on a nominal basis on US high yield today, these end up with a minus 1% expected return.”
With cash renewing its relevance in investor portfolios, Tavazzi says the sea change will have impacts on how investors should build their portfolios.
When the cash yield was zero, clients that bank with Pictet did not know where to put their money. Today, that discussion has changed. Tavazzi says: “Because people would say, ‘if I wait, I’m paid to wait', and that’s a major change in the attitude of investors. For a U.S. dollar-based investor, the fact that you decide to stay on the sidelines or buy a six-month treasury bill will give you about a 5% [nominal] return. That’s a substantial change in terms of how people can build their portfolios.”
Long-Term Predictions
In this year’s report, base effects and higher inflation have boosted overall return expectations for the next 10 years.
For example, U.S. investment grade credit is predicted to generate an annualized return of 5.4%, more than double the return given out over the last 10 years. For high yield, U.S. issues are expected to return 6.9%, and European issues to return 7.9% every year.
Although bond returns are expected to improve meaningfully, multi-asset investors should not overlook the gap between relative and absolute returns. Tavazzi continues: “Now the difficulties what you see is on the real basis, we see only two countries where those will be above inflation and those countries are the United States and the second is Switzerland, where the inflation rate is low.”
Earlier this year, Philip Straehl, global head of investment management research at Morningstar Investment Management, provided his return projection of a 60-40 portfolio beating inflation by 3.6% over the next 20 years. The prediction also represents a 1.6% improvement from a year ago. For that, Straehl also cited that the 10-year US real yields are at their highest level since 2009, which could “offer meaningfully positive return prospects after inflation.”
Pictet WM ‘Substantially Revises Down’ China
Reflecting lower growth prospects for the Chinese economy, Tavazzi says the team has substantially revised downward his expectations for the country’s real risk-adjusted return expectation for the next 10 years to be annualized around 3%.
“In the coming years, we will see a different source of profits in the Chinese equity market. The sectors which have been favored by investors over the last five to 10 years will not be the ones which are going to be favored now,” says Tavazzi, who cites a shift in regulations as well as the development of a new economy as reasons. The latter includes increased use of green energy as well as wider adoption of electric vehicles
“So when you look at Chinese equities today, the mismatch is probably between the heavyweights of the index and what you want to have in your portfolio. The new growing industries are not big today,” Tavazzi adds.
For those who still want to venture into China stocks, Tavazzi advocates an active approach. “You have to address the market by being an active investor, not necessarily playing the index as a whole because, in that index, you have the winners of the past years, which, because of the changing nature of the growth, will probably not be the winners in the coming years.”
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