1Q:2022 Strategic Investment Outlook: Four Strategic Allocation Issues for Asset Owners in 2022

Introduction

In this note, we discuss four strategic issues that could have far-reaching implications for asset owners in the year ahead. Our subject matter is strategic, not tactical, so this is in no way an attempt to provide a comprehensive “2022 outlook.” However, the narrative for each of these issues is evolving rapidly, so we think they will feature prominently in discussions of asset allocation this year:

• A transition year for inflation—and the need to respond
• The role of crypto and digital assets in portfolios
• Has the private asset rotation gone too far?
• Equity real-return prospects and liquidity risks

The action points that stem from this analysis are tangible in terms of both required portfolio changes and general adjustments in approach.

For inflation, 2022 is likely a transition year in which the forces at work shift from short-term supply and demand imbalances to more fundamental forces. So, investors should be prepared to update their strategic views of post-pandemic inflation. More tangibly, we think asset owners need to increase exposure to physical real assets and consider exposure to equity market beta and the value factor within equities as part of their response to persistently higher inflation. In time, we think other assets, such as renewable power delivery and possibly tokenized real assets, will become important parts of this allocation.

Crypto and digital assets are not realistic investment opportunities for many asset owners in 2022. Crypto assets face tactical risks related to the near-term liquidity of risk assets, though longer term we see a more positive case, while tokenized assets are too nascent for investment this year. However, asset owners need to rethink their allocation approach to allow for possible future investment, which requires conversations now about governance, regulation and portfolio construction.

The year ahead will undoubtedly see the tidal wave into illiquid assets continue. Given the macro setup, many asset owners have no choice but to increase risk levels, with taking on more illiquidity risk one option. We think that the marginal extra investment is more likely headed into private debt and real estate rather than private equity, given our concern about the level of dry powder. Developing new categories of investible assets, such as renewable power delivery and green infrastructure, is an important strategic theme.

We are strategically positive on equities. In a moderate inflation regime, we think they can deliver a positive real return, albeit below the levels investors have become accustomed to. Moderate inflation and low real yields can support valuation multiples, and we think investors will need to raise exposure to equities, given their role as a liquid real-return asset. The strategic limits to returns stem from high valuations and the long-term downward pressure on margins, as the pendulum swings from capital to labor. In the near term, liquidity is a source of risk, especially as central bank support winds down.

Inflation 2022: A Year of Transition and Adjustment

Saying that inflation is a key issue for investors in 2022 risks stating the obvious. However, investors face two specific strategic inflation-related issues this year. First, 2022 will likely be the transition year from inflation being driven by extreme supply and demand pressures to inflation instead being driven by longer-term forces, including labor market dynamics. Second, this could be the year when a larger adjustment is made to strategic portfolio allocations. One action point for investors is to be ready to update their strategic beliefs about inflation in response to labor market data in 2022. The other is a call to action to insure portfolios against inflation, which will mean different things to different investors.

In our previous in-depth piece on inflation (Assessing the Inflation Trajectory—and Portfolio Responses), we pointed out that once the immediate supply and demand pressures of reopening have abated, both strategic inflationary and strategic deflationary forces will be at work.

The deflationary forces are automation and the likelihood that savings rates must rise as individuals face lower real investment returns. The inflationary forces are environmental, social and governance (ESG), a shrinking labor force, and a swing in the balance of power away from capital and toward labor.

Above and beyond these forces, we think government debt burdens in line with those at the end of WWII will likely boost inflation. Growing out of the debt seems unlikely, and austerity is not a realistic political option. Some of these forces are very long term in nature, with wages likely to be the most pressing force for the next couple of years.

A key question is: How tight is the labor market really? The coming year will likely give us much of the answer. Across the world, governments’ pandemic support for labor (whether unemployment support or furlough schemes) will have abated (barring an unforeseen development). It will also become clearer who exactly is a member of the labor market—an important point, with the participation rate still stubbornly below its pre-pandemic level.

In the US, labor participation rates are still below pre-pandemic levels for all age groups, but the biggest proportional decline is among those 55 years and older (Display 1). Looking closer at this age group, most of the decline comes from those aged 65 and older, while the participation rate for the 55–65 age group is almost back to pre-COVID-19 levels.

Is the decline temporary or permanent—in the form of retirement? A key consideration in the answer is whether older workers pushed out of the labor force during the pandemic have enough savings to afford retirement. 

Display 2 shows the wealth distribution of the 65 and over age group based on 2019 data. It’s challenging to match data on wealth distribution with employment. However, if one assumes that the poorest end of the wealth distribution is more likely to stay in the workforce and applies this assumption to the decline in the participation rate during the pandemic, it suggests that the marginal individual in this age cohort that left the workforce had a net worth in the $100,000–$250,000 range. 

This is unlikely to be enough to fund a retirement, so presumably at least some of these individuals will wish to return to the workforce when the opportunity presents itself or when the risk of infection wanes. This is at least one piece of evidence suggesting that some of the current extreme tightness in labor markets may ease.

We stress that the focus of this paper is strategic, not tactical, so our real focus is on the longer-term dynamics of labor bargaining power. One recent piece of evidence supporting some level of long-term inflation from the labor market is the ever-so-slight uptick in union participation in the US in 2020, combined with the most recent Gallup survey showing support for unions at its highest since 1965 (Display 3). This development is, we think, part of a bigger global trend that is likely to see a shifting balance more in favor of labor than capital compared with the neoliberal status quo of the last few decades.

The action point for investors is to consider how to insure portfolios against higher inflation. This will mean different things to different investors. For an investor with a very long savings horizon, inflation “insurance” likely means finding sources of real return, while for an investor with a shorter horizon or lower risk tolerance, it might mean explicitly finding a return stream correlated with inflation. In Display 4, we list the most effective assets at meeting these two goals—both in periods of moderate inflation in the 2%–4% range (our expectation) and in higher inflation regimes.

In Display 5, we show more detail on the effectiveness of various return streams in moderate and high inflation regimes. The average ability of assets to generate real returns in inflationary regimes is a key consideration, as is their ability to hedge equity beta. In moderate inflation regimes, at least, equity exposure will likely be a key part of the solution. Because of that, we think equity allocations will be high, but traditional fixed-income products are less likely to offer their traditional hedging ability for equity risk as inflation rises.

The bottom line: an equilibrium level of inflation above the pre-pandemic level demands a response from asset owners. The response must be viewed in the broader context that nominal returns for many asset classes will likely be lower, given the decline in yields. There is no one solution, and the answer will vary depending on investors’ risk appetites. However, we suggest that the bulk of this portfolio adjustment is still to come. Some of the key allocations that need to be made (subject to investor type) are:

• Maintain high equity exposure
• Consider strategic exposure to factors—both long-only and long-short—including value
• Commodities exposure (as long as it’s not explicitly curtailed by ESG considerations)
• Physical real assets exposure (including real estate, infrastructure and farmland)
• Gold exposure and (for a limited group of investors) crypto assets

This change in allocation will also likely be a catalyst to accelerate the “financialization” of other forms of real assets. Examples that we think could help offer inflation protection for portfolios include renewable power delivery, green infrastructure and tokenized real assets. These assets already exist, only in very small size, but we think they’re all likely to become greater allocations in portfolios, particularly for pension funds. 

The Role of Crypto and Digital Assets in Allocation

The role of digital assets and cryptocurrencies continues to spur questions in client meetings, to such an extent that we suggest it as a key strategic theme for 2022. It is not actually a single theme but a myriad of related investment topics: There are macro questions about the role of cryptocurrencies and central bank digital currencies (CBDCs) and how they may shape the global economy and policy. There are strategy questions on the role that such technology can play in corporate profitability, decentralized finance and in determining leadership within markets. There are also questions surrounding portfolio construction and the role of crypto and other digital assets as a source of return and diversification (or not!). Finally, there’s the growing role of blockchains as the mechanism for the functioning of markets and the distribution of financial products.

We think that all these facets will be important topics for investors, and 2022 is likely to give further clarity for investors in a number of these areas. Here, we focus on the role of these assets in portfolio allocations: the scope and pace of CBDC development, more detail on the level of regulatory acceptance for investment in crypto assets, and more tangible steps toward truly investable tokenized real assets. Moreover, despite recent volatility, we think that the likely path is toward greater institutional investment in crypto assets.

We’ve pointed out that 2022 could be the transition year when inflation forces switch from short-term supply and demand distortions to longer-term effects (the labor market and changing policy choices). If that view is right, then we expect an acceleration in portfolio adjustments to establish a more strategic allocation to inflation insurance.

There’s no empirical evidence yet that crypto assets can be a diversifier (of either inflation or equity beta), but these are still very immature assets. We think there’s a case that demand for zero-duration non-fiat assets will increase, especially if the policy path becomes tolerant of, or even implicitly encourages, currency debasement as a way out of current debt levels. Gold would be the first port of call, but we could also see demand for a broader set of assets. We don’t think empirical evidence of inflation-hedging properties will emerge over the next year—such a shift, if it happens, will take longer.

There’s a bigger picture here: in such an environment, fixed income is less likely to diversify equity risk, so hunting for strategic diversifiers will become an urgent need. Gold has a near-zero correlation with equities that are maintained at higher inflation levels. There’s a possible case for crypto to play a similar portfolio role in the future. 

This is unlikely, however, to be a one-way shift. As discussed elsewhere in this note, a likely reduction in macro liquidity is a significant risk for 2022. This could affect all risk assets but is potentially even more of a challenge for more immature assets with concentrated holdings, such as Bitcoin. Therefore, any possible future role as a portfolio diversifier is very firmly a strategic trade—not a tactical one.

Cryptocurrencies, such as Bitcoin and Ethereum, remain significantly more volatile than equities and gold (Display 6). The correlation between cryptocurrencies and US equities has been declining from its 2020 peak. However, cryptos remain slightly more positively correlated to equities than gold, which has a 12-month rolling correlation of nearly zero, underlining the point that cryptocurrencies’ ability to diversify remains more a question of long-term potential than tangible reality.

Since 2015, the correlation of US equities, gold and cryptocurrencies with US inflation expectations has been close to zero with occasional spikes higher, such as at the end of 2018 and during 2020. On average, Bitcoin and Ethereum had a slightly more positive correlation than gold to the 10-year break-even inflation rate. Since July 2021, however, there’s been a notable divergence (Display 7): the correlation between gold and inflation expectations has become more positive, while that between inflation and cryptocurrencies drifted lower.

In previous research, we’ve pointed out that we don’t believe that it is possible to value a cryptocurrency like Bitcoin, but one can conduct a “scaling” exercise. One point of concern for us is that the total value of cryptocurrencies exceeded the value of gold held for investment purposes for the first time in 2021, although in recent months crypto has fallen to around $2 trillion again (Display 8). There’s no rule dictating how large crypto assets should be relative to gold, but if crypto assets are significantly larger, it implies that in some sense, crypto is “better” than gold for investment purposes.

We think it’s more likely that both assets rise together over time rather than crypto significantly exceeding gold. The exception could be if crypto’s main ownership is not for investment purposes. In that case (such as gold, where more is held as jewelry than investment), the value of crypto could rise further.

There are several links between the strategic case for inflation and cryptocurrencies—and not just from crypto’s possible future role as a hedge. One difficulty authorities faced in trying to raise inflation in the years before the pandemic was the persistent fall in the velocity of money. Velocity is by no means the only source of deflation, but it’s an important factor in the challenge of finding an effective policy solution.

There are numerous reasons for the long-term decline in the velocity of money, but the erosion of bond yields and rising wealth inequality across society are likely keys. Rich people tend to save more, so both of these forces contributed to a higher savings rate and lower velocity. We think that, other things equal, the velocity of money could fall even further. When investors realize that the nominal return on their savings is going down, and that both the risk around those returns and inflation are rising, they’ll likely react by increasing savings rates even more. Moreover, we don’t think the degree of inequality will change anytime soon, despite it becoming a key policy debate in many countries.

It’s been suggested that a technological innovation, such as the adoption of CBDC or crypto, could arrest this decline by changing the way money is used. Any shift that increases the velocity of money could be exceedingly helpful for policymakers: despite the current tactical fixation with high inflation, we suspect that background strategic deflationary forces are still a concern.

The possibility of faster settlement for some transactions and a broader reach of banking services globally for those with limited access could increase money velocity. We’ve never seen such a shift to digital money before, so it’s hard to be sure, but if we focus on the payment technology aspect of the transition, the evidence suggests that CBDCs and crypto will not increase velocity. Prior innovations in payments technology have, if anything, occurred as the velocity of money has fallen.

At the very least, it appears that payments technology has failed to offset larger forces at work. In Display 9, we show the long downward shift in the velocity of M2 in the US starting in the mid 1990s. The velocity of money kept declining, even as checks and cash payments were replaced by credit and debit cards as well as other electronic payment means. 

Sweden is probably closer to being a cashless society than any other country in the world. According to the central bank of Sweden, the use of cash has quickly declined, from 40% of transactions to 13% between 2010 and 2018—even before the pandemic. In many cases, businesses no longer accept cash, and surveys show that the majority of small businesses plan to stop accepting cash. However, the velocity of money supply in Sweden has declined rapidly over the past 10 years (Display 10), even as cash was replaced by electronic means of payment. 

Moreover, and from a very different angle, recent research¹ has shown that the adoption of cell phone payment technology in African countries that had previously had relatively poor banking penetration has resulted in the velocity of money declining, or at the very least failing to rise. Adopting digital currencies is not the same as jumping from checks to electronic payments, but we think that this experience offers, at the very least, circumstantial evidence that we should not expect the digital shift to increase the velocity of money.

What prospects do the next one to two years hold for CBDC and cryptocurrency regulation? According to CBDC tracker website,² only a handful of countries, including China, Canada, France, South Africa, Nigeria, Ghana, Uruguay and UAE, have reached the piloting stage for a CBDC program. A few other countries, such as Sweden, South Korea, Turkey, Japan, Ukraine and Thailand, have advanced proof-of-concept projects.

Meanwhile, the US, the UK, Australia, India, Brazil and other countries are still only at the research stage. The Bahamas is currently the only country that has officially deployed a CBDC. Most nations don’t have a firm timeline for CBDC launch and adoption but, according to press statements by the European Central Bank, Bank of England and Sveriges Riksbank, this is not expected to happen until at least 2025. It’s often pointed out that the US may have to pursue a CBDC because it wouldn’t want to cede a significant share of international payments to China. However, that motivation is unclear, because while China has capital controls, it’s not evident that a digital yuan could even take on such a role.

With respect to the regulation of crypto assets, 2022 is likely to bring more clarity. Securities and Exchange Commission (SEC) chair Gary Gensler has called for more regulation of cryptocurrencies and related financial products. Most recently, he noted at a meeting of the Investor Advisory Committee that crypto is an “asset class that belongs inside public policy frameworks of looking after investors, guarding against illicit activity, and protecting our financial stability.”³ He also noted significant gaps in investor protections in decentralized finance platforms, crypto lending and other related financial activities. According to Gensler, platforms offering securities fall under the SEC’s jurisdiction.

Dollar-backed stablecoins have been a regulatory concern in recent months. The President’s Working Group on Financial Markets, comprising the Secretary of the Treasury and heads of all key US financial regulatory bodies, noted that stablecoin issuers should become “insured depository institutions,” on par with banks that offer savings accounts for customers.⁴ Currently, only Bitcoin futures exchange traded funds (ETFs) can trade in the US market, and the SEC continues to reject proposals for ETFs backed by physical Bitcoin. In the past few months, the SEC has rejected VanEck’s and WisdomTree Investments’s applications for spot Bitcoin ETFs, arguing that the commission still lacked confidence that the Bitcoin market was free of manipulation and fraud.⁵

We also think the next one to two years could be important ones for making tokenized real assets more tangible (Display 11). In previous research (Inflation and the Shape of Portfolios), we noted real estate as one area that’s particularly well suited for tokenization and that should see widespread adoption in future. Despite a few high-profile efforts at real estate tokenization in recent years, such as the $18 million tokenization of St. Regis Aspen Resort in Colorado, the market is still in its infancy.

A September 2021 joint study by Hamburg Commercial Bank and the Frankfurt School Blockchain Center think tank suggested that only an estimated 41 companies in 17 countries, including the US, Germany and Switzerland, had been trialing property tokenization.⁶ And the overall size of tokenized real estate is still minuscule compared with the real estate or alternatives markets. While estimates are scarce and highly imprecise, one recent study by Forkast.News⁷ estimated the total value of tokenized real estate at around $130 million.

What’s Next for the Private Asset Rotation?

One major theme for 2021 will likely be the ongoing rotation from public to private assets and the further move down an illiquid path for portfolio composition. There are good macro reasons for this trend, but it does beg further questions: How do we know if it has gone too far? What parts of illiquid allocations should grow the most from here? What effect does this rotation have on assets and financial stability? We will address these questions here and touch on this last question in the next section.

Our recent note on private assets (Private Assets and the Future of Asset Allocation) pointed out that the macro setup implies asset owners should have higher allocation to private assets, driven by these forces:

• Low expected returns across public markets
• Diversification becoming harder to achieve
• A strategic case for moderately higher inflation
• The lack of listed “young” growth companies
• More-fragile liquidity in public markets

If this is the background investment decisions are set against, we suggest that asset owners seeking a given level of real return have no choice but to take on more risk, which can take various forms. Buying illiquid assets is one such response, as is increasing leverage, taking more factor risk and making greater use of alpha as opposed to asset betas to meet targets. The main strategic conclusion is that asset owners must be as efficient as possible in taking on these risks in a way that cuts across asset classes and the public/private divide.

But illiquid assets are no panacea: lower expected returns may well apply to private assets too. Also, some of the apparent diversification from private assets may be illusory. Stale prices are, after all, not to be confused with diversification. But the tolerance of illiquidity in a portfolio should be linked to the investment time horizon and governance procedures for managing assets. Setting that horizon is a critical part of this shift, and illiquidity tolerance could then be an endogenous process.

How far will the private rotation go? Asset owners have been rapidly moving toward a barbell in the way they take active investment risk in their portfolios, because of the confluence of two huge forces: the rotation to illiquid assets and the flight from active to passive investing in public markets, especially equities. 

Just before the pandemic, we saw the proportion of capital allocated to active risk in equities fall below that of alternatives, with illiquid assets a significant part. It’s hard to get comparable historical data, but given that active equity risk has been an investing mainstay for decades, it’s likely that this is the first time more capital has been allocated to active risk in illiquid assets than in public equities since before WWII.

In Display 12, we show the amount of capital allocated to active equity investing versus alternatives. To calculate it, we multiply the portfolio allocation of stocks, bonds (not shown) and alternatives by their respective shares of actively managed AUM each year, assuming that 100% of alternatives is actively managed. We then rescale each series as a proportion of actively managed assets. 

On this basis, the share of actively managed alternatives surpassed actively managed equities at the end of 2018. Over the course of the pandemic, the flight from active to passive has accelerated, as has the rotation into illiquid markets, so it’s likely that the latest data will show a further extension in this trend. Moreover, this chart is shown in simple assets under management (AUM) terms. It’s hard to directly compare the amount of active risk taken, but given that much of the active equity exposure will have a tracking error below 5%, the allocation to alternatives on a risk basis will be much more significant.

How much further can this trend go? The question has to be unstitched into the underlying forces at work: in other words, the shift from liquid to illiquid and the path from public active to public passive exposures. For the former, this comes down to the expected return on illiquid versus liquid assets and the appropriate amount of illiquidity given the investment time horizon.

We’ve long been asked this question in meetings: How far can the active-passive rotation go? We believe that one can’t rely on any “natural” mean reversion determined by market efficiency or even from capital allocation in society (the basis of our “passive is worse than Marxism” argument).⁸ The market doesn’t have an effective feedback mechanism to bring about such a change.  Instead, we suggest that the limit will ultimately be set by asset owners themselves. Our view is that if asset owners continue in the same vein as the past decade, they’re going to be disappointed in the return level they achieve. The macro situation demands a change of approach. Asset owners will need to allocate risk to active strategies in order to achieve their needed level of real return. This is the much-needed epiphany of asset owners, and it’s their need for returns that sets a limit to the active-passive rotation.

The expected return outlook on the average private equity investment seems significantly lower than history for three reasons: (1) the increase in buyout multiples suggests that average future returns are lower (Display 13), (2) the buildup of dry powder implies the risk of a delay in deploying capital, and (3) the longer history of private equity returns was achieved against the very generous backdrop of declining bond yields and narrowing credit spreads.

In Display 14, we show the progression of investment return/risk implied by the macro outlook and asset owners’ allocation choices. The basic 60/40 model has worked well in recent decades. Over the last decade, exposure to more illiquid assets has been added, boosting portfolio Sharpe ratios. However, if we apply our future return projections to that current allocation, it implies a significant decline in Sharpe ratios, as shown by the point labeled “prospect for the current model for SAA.” That is the starting point for future asset-allocation changes. There are a number of potential ways forward from there. One example shown is to ameliorate this decline in expectations by broadening private asset exposure.

Global Equities: Still a Pillar for Real Return Seekers

This note focuses on key themes for 2022 that affect the strategic multi-year outlook. So, while our focus isn’t tactical, it’s hard to avoid making the global equity market one of the key themes. For one reason, in a world of moderately higher inflation, equity beta will likely be a core element of investors’ returns. Our central expectation is for low single-digit positive real returns for coming years.

However, with high valuations, uncertainty about liquidity and an unpredictable macro policy environment, there are clearly risks to this outlook. Another run of high returns seems unlikely—there’s a path to that outcome, but one would have to assume another leg of fiscal support, and it would likely also imply a strategic outlook of even more dominant mega-cap names as a route to pushing aggregate profitability even higher. This seems ultimately unlikely, from the perspective of political acceptability.

Over the past year, global equity funds have seen an inflow of US$1 trillion (Display 15). In terms of regions, US inflows have been very strong throughout the year and emerging-market inflows held up despite the volatility in the Chinese market, while outflows from Europe continued. 

The huge scale of the overall inflow and the very strong return from equities have pushed the US household equity allocation to an all-time high of 51%, exceeding even the allocation reached at the peak of the dot-com bubble.

The issue has to be whether these flows and allocation level together are a worrying sign of equity sentiment being too high, often a contrarian signal.

Rather than repeat ad nauseam the point that equities are expensive versus history (which is a risk but hasn’t made a difference for equity returns over the past decade), we think liquidity is a more pertinent issue for investors in 2022. There are three interrelated issues here: the Fed’s taper, increased asset-owner allocations to illiquid assets and the likelihood of more fragile public-market liquidity. It’s hard to quantitatively build this mix into return expectations, because we’ve simply never been in this situation before, and liquidity tends to “matter only when it matters,” anyway.

As for the Fed’s taper, Display 17 shows the three-month average forecast of US Treasury bond issuance and the Fed’s planned path of purchase reductions. While there’s uncertainty around month-to-month issuance forecasts, the peak disconnect between issuance and Fed purchases will likely be at the end of 2021 and the start of 2022, meaning that the switch from quantitative easing to quantitative tightening is upon us.

As we detailed in the previous section, the past decade saw a huge shift in institutional investors’ asset allocations from liquid and actively managed public assets to illiquid alternatives. Over the past 10 years, the overall public equity allocation of investors declined from 47% to 39%; at the same time, the share of alternatives (a significant share is illiquid assets) grew from 16.5% to 22%. This increased the pressure on the remaining liquid portion of portfolios in a stressed market environment.

The average liquidity of equity markets has improved over the past decade, but other important considerations make liquidity likely to be more fragile. We would cite: changing market structure, with the growth of high-frequency trading (HFT); the rise of ETFs and evolving regulations leading intermediaries, such as banks, to take less risk; a dearth of active value investors (buyers able to step in to buy overly discounted assets); and growing corporate debt combined with declining debt quality.

There is evidence⁹ that HFT liquidity dries up when volatility is higher, and the rise of ETFs has pushed more market volume into a shorter period around the market close rather than being dispersed throughout the trading day.

This isn’t enough to make us bearish on equity returns, especially not over strategic horizons, but it constitutes a key risk. Aside from such technical considerations, what about the fundamental outlook? We note that margin expectations are for US margins to rise for the next two years. That’s plausible, given the investment in automation during the pandemic and the large weight of very profitable mega-caps (shown by the higher profitability of large cap–weighted indices).

Investors who want to consider longer horizons need to be aware of the limits to how far profitability and corporate profits as a share of GDP can rise. This is ultimately a sociopolitical question. An environment where capital has had more bargaining power than labor, mega-caps have become even larger and taxes remain low has contributed to the record profitability. However, we see strategic limits to this trend, and we think policymakers will push back, either as part of a rebalancing from capital to labor or on competitive grounds. So, while pre- and post-tax margins can remain high in the near term (Display 18), we expect them to fall over strategic time horizons.

On a related point, the long-term earnings expectations from analysts are showing signs of extreme optimism. At around 18%, expectations are at the highest level in history both in Europe and the US (Display 19).

Altogether, this amounts to a strategic equity outlook that’s positive; we would expect US and global equities to deliver positive real returns, albeit at a rate below that of recent years. Within the context of lower expected returns and compressed Sharpe ratios across the whole book of investments, however, equity beta will likely be an important source of achieving the required level of return.

On a strategic time horizon, the limitations to equity returns stem from high valuations and margins. High valuations do not imply a bearish outlook, especially if real yields remain low, inflation finds a “moderate” equilibrium and there’s broader acceptance that fiscal support is likely to be used whenever the next recession happens. Margins can continue to rise in the short term, partly because of investment in automation during the pandemic and the potential for higher profitability of mega-caps.

The bottom line is that our strategic outlook for equities is low but positive real returns. For investors whose ultimate target is to earn a spread over inflation, equity beta is likely a core part of their allocation despite higher valuations or worries over liquidity.

Within a global equity allocation, we would continue to favor a strategic allocation to US equities despite the already sizable inflow there versus other regions. An environment of moderate inflation, but with interest-rate hikes falling short of commensurate increases in previous cycles, means that emerging-market exposure would be a region to add alongside the US.

From a factor perspective, a global allocation to value equities, albeit with a lower allocation to financials, would be appropriate given the inflation outlook. However, that value allocation still leaves space for an allocation to US stocks that display sustainable growth profiles—in a low-real-yield world, such “long duration” allocations within equities still have a role.

Finally, we would note that the average correlation of stocks with the equity market has markedly declined recently (Display 20). We can show that periods of stock correlation decline create more potential for active managers to outperform, a topic we discussed in more detail in a recent Alphalytics note.¹⁰ So, alongside a high allocation to equity beta and the broad themes we’ve described, we also see another action point for investors: include allocations to active idiosyncratic alpha strategies within equity exposure.

Conclusion

In this note, we’ve selected four topics that we think are key for any debate of the strategic investment outlook in 2022. While this is definitively not an outlook for 2022, we think that these topics are interrelated and will all be key parts of investors’ debate about allocations over the next year.

For inflation, the message is in part to prepare to update strategic expectations as the forces at work shift over 2022. However, the key action item is to rebalance portfolios to protect against inflation, a transition we think will take place in earnest over the next 12 months.

The rotation to illiquid assets is so mature a process that the fact that it continues is not newsworthy. What is critical, however, is its evolution in expanding outward from its past focus on private equity. This evolution is also bound up with innovation in the expansion of the universe of assets regarded as investible—itself a core message of our section on crypto and tokenized assets.

¹ The impact of mobile money on monetary and financial stability in sub-saharan Africa, GSMA 2019, available at: https://www.gsma.com/mobilefordevelopment/wp-content/uploads/2019/03/The-impact-of-mobile-money-on-monetary-and-financial-stability.pdf
² https://cbdctracker.org/
³ https://www.sec.gov/news/statement/gensler-iac-statement-120221
⁴ https://home.treasury.gov/news/press-releases/jy0454
⁵ https://www.coindesk.com/policy/2021/12/02/sec-rejects-wisdomtrees-spot-bitcoin-etf-application/
⁶ https://www.hcob-bank.de/en/editorial/pages-2021/editorial-page-ppa-studie-0/
⁷ Tokenized asset market sizing and analysis (forkast.news)
⁸ Inigo Fraser Jenkins, Paul Gait, et al., “Fund Management Strategy: The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism,” Bernstein Research (August 23, 2016)
⁹ Nataliya Bershova and Dmitry Rakhlin, “High-Frequency Trading and Long-Term Investors: A View from the Buy-Side,” Journal of Investment Strategies, Volume 2/Nr 2, Spring 2013 (3-47)
¹⁰ Alla Harmsworth, Harjaspreet Mand and Ravi Verma, “Alphalytics: Active returns in a synchronized world,” Bernstein Research, December 20, 2021.