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Investment Strategy

Investing for a world in transition

Oct 16, 2023

Authors: Grace Peters, Monica Issar, John Bilton

 

The changes are profound—if in some ways elusive. Today much of what defines the investing environment is in transition. But we may not appreciate the breadth and depth of the change.

Consider:

  • The economy is in transition as persistent disinflation transitions to two-way inflation risk.
  • Policy is in transition as ultra-easy monetary policy transitions to more conventional monetary policy and fiscal restraint shifts to fiscal activism.
  • Technology is in transition as the potential of artificial intelligence (AI) begins to emerge.
  • Climate is in transition from conventional energy to renewable energy.

For investors this is an empowering moment in many ways, and it requires action—building smarter portfolios for a world in transition.

With the economy and asset markets in flux, portfolios themselves may also need to also make a transition. This became especially clear in 2022, when investors learned that bonds hedged risky assets against growth shocks but did little to hedge against inflation shocks.

Today, we believe that a 60/40 allocation (60% equities, 40% bonds) can once again form the bedrock of portfolios. But there is so much more to explore beyond the 60/40. Markets now appear to be offering a promising and diverse opportunity set, whatever your outlook is on return and risk tolerance. 

That’s one of the key takeaways of the recently published 28th annual edition of J.P. Morgan Asset Management’s Long-Term Capital Market Assumptions (LTCMAs).

Goals-based plans, optimized allocations

The LTCMAs are the work of more than 60 investment professionals from across J.P. Morgan Asset & Wealth Management. They scrutinize over 200 asset and strategy classes to provide return outlooks over a 10- to 15-year investment horizon. These annual outlooks help to drive our strategic asset allocation and power the tools we use to build portfolios tailored to your goals.

When you sit down with your J.P. Morgan team to craft or review your goals-based plan, J.P. Morgan Asset Management’s return assumptions help create a more informed and personalized investment framework—one that considers your unique circumstances, risk tolerance, liquidity needs and desired financial outcomes. Updating your plan every year with our latest outlooks can also help optimize your asset allocation and provide a clearer path toward achieving your financial goals with confidence.

Extend, expand, enhance

To build a smarter portfolio—one that can help seize the opportunities of a world in transition while mitigating the associated risks—the LTCMAs suggest that you consider taking steps to:

Extend out of cash and delve deeper within core assets

Cash rates may be high today (and it’s always important to have the right amount of cash in a properly funded liquidity bucket). But historically, every major asset class has performed better than cash over the 10- to 15-year LTCMA investment horizon.

Consider expanding the opportunity set, especially with alternative assets (including real estate, infrastructure, private equity and hedge funds)

The LTCMAs suggest that real assets in particular can help protect against inflation and provide portfolio diversification benefits. But it’s important to remember that investing in alternative assets often involves a greater degree of risk than investing in traditional assets.

Enhance portfolio outcomes through active allocation and manager selection

Bear in mind that the LTCMA potential market returns are “beta” only—that is, they reflect market returns but not any possible added returns from manager selection. And given the higher cost of capital expected over a 10- to 15-year investment horizon, manager selection can play an increasingly important role. 

This chart shows the building blocks of building a smarter portfolio. Build on your 60/40, extend our of cash, enhance with active, and expand the opportunity set.

Slightly higher growth and inflation

Building long-term outlooks begins, as always, with a macroeconomic perspective.

This year’s LTCMAs consider the impact of multiple transitions, across the economy, policy, technology and energy. These transitions will likely have varying effects on global growth and inflation, at different times and in different regions and sectors.

We see a positive impact on growth from the technology transition. While the timing and magnitude is uncertain, we expect that AI will help increase productivity, which could boost GDP. Improved labor force growth in the United States and increased investment in the energy transition in Europe could also support growth.

On balance the LTCMA  global growth assumption rises slightly, to 2.4%.

Higher inflation is expected. For example, in the United States, euro area and United Kingdom, the LTCMAs assume a 2.4% rate over the next 10 to15 years, well above the pace of the 2010s.

Stronger wage growth helps boost inflation assumptions from 1.8% to 2.2% in the euro area and from 0.9% to 1.4% in Japan (where any inflation at all had long seemed an improbable prospect). The LTCMA U.S. inflation assumption falls slightly, from 2.6% to 2.5%.

Potential for higher bond returns, lower equity returns

High central bank policy rates support the LTCMA fixed income assumptions: The USD cash assumption (think, for example, of the rate on money market funds)  rises 50bps, to 2.9%. The assumption for Global Aggregate bonds (global government debt,  investment grade corporate and securitized assets such as agency mortgage-backed securities) jumps 40bps, to 5.1%.   

Following the reset in yields, real bond returns could be robust across the fixed income complex. Critically, we believe investors can again rely on bonds both for income and diversification from disinflationary growth shocks.

The LTCMA expected equity returns fall in the wake of the 2023 rally, but not as far as might be expected. That’s partly because the outlook anticipates that corporate profit margins will be higher than the historical average. The view reflects the increased market value of particularly profitable, high return on capital companies (many in the tech sector).

Even so, the LTCMA outlook for global equities dips 70bps, to 7.8%—still a solid potential return. In addition, in the LTCMAs, the gap between developed market and emerging market equity return assumptions narrows this year.

U.S. large cap return assumptions decline from 7.9% to 7.0%, reflecting higher valuations. The LTCMAs see an attractive outlook for non-U.S. developed markets. Profit margins will be supported by various factors, the outlook suggests: in Europe, a sectoral shift to more profitable and higher return on asset sectors; productivity enhancements, including the increasing adoption of AI; and pricing that does not revert fully to pre-pandemic levels.

By contrast, the LTCMA assumptions for emerging market equity have moderated. Investors are increasingly skeptical about the outlook for Chinese equities and unwilling to pay high multiples. However, because Chinese stocks did not participate in the 2023 rally, a lower starting point supports estimated returns.

Alternative assets: Inflation resilience, potential for stronger returns

Alternative assets are arguably the brightest spot in the LTCMA return outlook this year. (We again note that investing in alternatives often involves a greater degree of risk than investing in traditional assets.)

The case for investing in private markets comes from the inflation resilience that alternatives have demonstrated as well as from improving return assumptions.

The inflation-hedging benefits of real assets (including infrastructure, real estate, transport and timber) could prove especially useful over the LTCMA investment horizon. The return outlook  for global infrastructure (core), which could get a boost from the ongoing energy transition with assumptions, rising from 6.3% to 6.8%. 

Despite some well-flagged issues in some segments of U.S. commercial real estate and persistent weakness in China, we believe that the outlook for core real estate is strong. (For example, the U.S. core real estate assumptions rise from 5.7% to 7.5%).

The LTCMA  return outlooks for financial alternatives are more mixed—they rise sharply for venture capital and direct lending and fall modestly for private equity (following equity market returns lower) and hedge funds. 

Real Estate income has generally outpaced inflation over the past 30 years

Source: J.P. Morgan Asset Management GRA Research, NCREIF, Bureau of Labor Statistics. Data as of June 30, 2023.
This line chart shows real estate income and inflation from 1991 to 2023. The data shows that real estate income has generally outpaced inflation over the past 30 years, according to J.P. Morgan Asset Management GRA Research.

Across all alternative sectors and strategies, future performance may exhibit wider dispersion of returns, depending on the individual manager. That dispersion underscores the importance of manager selection when investing in alternatives.

Currency: A new path to dollar decline

In our view, the U.S. dollar (USD) remains overvalued and looks set to decline against most other currencies over a 10- to 15-year investment horizon. However, over the longer term, we think that shifts in capital flows, rather than pure interest rate and economic growth differentials, will dictate the path of currencies.

Here, we focus in particular on the eurozone and Japan. The two regions struggled through a long stretch of stark underperformance in nominal growth, interest rates and equity markets. That period looks to have ended. As capital flows shift back toward the eurozone and Japan, their currencies will likely strengthen and compound the dollar decline.

The prospect of a new path to dollar decline may be of particular interest to our many clients whose portfolios are overweight USD and U.S. assets. Currency-hedging strategies are designed to help mitigate foreign exchange risk and may offer the potential for both portfolio returns and diversification.

Meeting the diversification challenge

Clearly portfolio diversification will be a persistent challenge as the economic environment moves through a state of transition. (Hiding out in cash may be tempting, but remember that cash has historically underperformed over the long term.)

Owning both stocks and bonds is a first principle of portfolio diversification—but it’s just a start. That’s because bonds do a good job of hedging  portfolios of riskier assets (for example, stocks and high yield credit) against economic growth shocks, but a subpar job hedging them against inflation shocks. Investors learned this lesson the hard way in 2022, when stocks and bonds both posted year-end losses for the first time since 1974.

One year ago, the LTCMA message focused largely on the jump in estimated returns for the core set of public market assets. This year, it is more about the breadth of opportunity available across the wider asset markets. When inflation risk is two-way (inflation could rise or fall) and stock and bond prices no longer reliably move in opposite directions, investors will need to explore different kinds of diversification to hedge portfolios and boost potential returns.

We can help

J.P. Morgan Asset Management’s Long-Term Capital Market Assumptions find that markets today may offer the potential for solid returns across asset classes and new opportunities for portfolio diversification. It’s a good time to build or revisit your goals-based plan to help ensure you are on track. Reach out to your J.P. Morgan team.

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