The coronavirus shock is likely having profound impact on how the economy operates over coming years. It is reinforcing structural trends and introducing new ones, such as the policy revolution, surging sustainability wave and accelerating deglobalization. In many ways, it is accelerating the arrival of the future. This has led us to change our long-term return expectations – and shift our strategic asset class preferences away from nominal government bonds and toward credit.
The latest update to our capital market assumptions, or return expectations across asset classes, reflects market price moves as well as the virus shock’s potential impact on fundamentals, such as corporate earnings, default rates and medium-term inflation expectations. Our expected government bond returns have fallen across the board, and those for credit and equities have broadly risen compared to the end of 2019. Our five-year expected government bond returns are now negative across developed markets, as the chart shows. Yields have dropped sharply, and we expect only a gradual rise as we see monetary and fiscal policy coordination suppressing rates in coming years. This diminishes the strategic case for holding nominal government bonds.
The significant price moves this year have played an important role in shifting return expectations. Potential changes in medium-term fundamentals also drive our return expectations. Take corporate earnings. The global equity market selloff earlier in the year had mechanically pushed up expected equity returns, but this repricing has been partly offset by a deteriorating earnings outlook. We see significantly reduced earnings per share this year before a gradual reversion over several years toward the prior trend of rising earnings. We also account for potentially higher corporate credit defaults and downgrades. Yet over a five-year horizon the sizeable widening in credit spreads that we’ve seen should compensate for increased losses due to defaults and downgrades, driving up expected returns for credit, in our view.
Another key factor is a nuanced inflation outlook. Inflation expectations have plummeted, yet we believe markets could start to price higher inflation risk once the near-term shock starts to dissipate. We see today’s extraordinary policy measures as increasing inflation risks over the medium term. Central banks could be more willing to tolerate inflation overshoots despite the upward pressure on rates from high debt levels, as monetary-fiscal policy coordination has become key. Accelerated deglobalization could add to inflation risks. The overall impact is not yet clear, and the greater risk of higher inflation in the long-run is so far not reflected by market pricing. This is why we favor Treasury Inflation-Protected Securities (TIPS) as a rising allocation in strategic portfolios versus nominal DM government bonds. We also see a case for Chinese government bonds as an increased strategic allocation. They offer higher expected returns just as DM bond yields have hit record low levels, and diversification in a world of increasing U.S.-China de-coupling.
Our strategic asset views are broadly aligned with our tactical views – with two important exceptions: TIPS and regional equities. We are neutral on TIPS over the next six to 12 months due to the collapsed near-term inflation outlook despite the more favorable outlook on a strategic horizon. Over the tactical horizon we hold a modest overweight on Asia ex-Japan equities on the prospects of a growth pickup in the region, likely led by China, which is gradually lifting lockdown measures. We are also tactically overweight U.S. equities for their relative quality bias and the strong policy response to date, and underweight euro area and Japanese equities for the limited policy space to safeguard the economy against the virus shock. We prefer credit to equities on both tactical and strategic horizons, and see private markets playing a core role in portfolios.