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Midyear Strategic Investment Outlook: What Does the Market Move Mean for Strategic Investors?

July 18, 2022
34 min read

 

Additional Contributors: Robertas Stancikas, Harjaspreet Mand and Maureen Hughes

Many people say they like to be long-term investors. It’s a laudable ambition, but often the short term gets in the way. Our notes typically focus on the strategic horizon, but when the S&P 500 falls by 20%, 10-year Treasury yields rise by 140 basis points and Bitcoin is down by 60% since the start of 2022, strategic investors need to respond. Rather than frame this piece as a typical “strategist” outlook for key capital-market assumptions, we anchor it on key strategic risk allocation questions for asset owners. We hope that this makes it directly relevant to the allocation decisions that asset owners need to make.

Does the often-heard phrase in recent weeks that “bonds are back” mean it’s time to rotate back into fixed income? Given the strong performance of real assets (especially versus financial assets), is that trade now “done”? Do investors still need to allocate to private assets given the downward shift in public asset valuations? Indeed, is the whole mantra of needing to shift into alternative assets now moot?

We discuss these questions in this note, which is not intended to specify an asset allocation—that’s a topic for individual conversations with asset owners through the lens of their specific requirements. Rather, we intend to help asset owners frame the impact of the abrupt market shift in light of their strategic asset-allocation decision. This note also updates views we’ve expressed in recent research on inflation, real and private assets, and equity markets.

All of this discussion must be seen in the context of the higher perceived risk of a US and European recession than was the case even a month ago. The time horizon of our note is longer than that of any presumed recession, but clearly a recession—or lack of one—affects the path of risk assets. So, we discuss the long-term outlook for equities and how a possible recession changes it.

Beyond the time horizon of the 2022–2023 economic slowdown, investors need to take a position on the longer-term equilibrium state that sets the context for strategic investing. Ultimately, this position comes down to a view on whether the pandemic represented a marker for a regime change or was merely a hiatus within an ongoing paradigm.

We believe that we’ve seen a regime change, and our strategic views flow from that stance. Can central banks bring inflation down to target through a conventional easing cycle or will inflationary forces persist? There’s a clear distinction between the very elevated inflation we see now and the longer-term inflation outlook beyond the next two years, because different forces are at work in each. This can be seen in the path of 10-year breakeven inflation rates in the US. The Fed’s increased hawkishness has eliminated the jump in long-term inflation expectations that happened after the outbreak of the war in Ukraine; they’ve now returned to the merely elevated levels of 2021.

As investors look beyond the next two years, we would argue that “sticky” residual forces are at work: deglobalization; environmental, social and governance (ESG), particularly the “S”; and demographics. All these forces point to a higher path of inflation, such as rising wages. Because the focus of this note is strategic long-term allocations, the implication of this inflation view is that investors must stay focused on generating real, not nominal, returns even after the current high inflation abates.

Finally, we’ll make the point that factors are back! After a decade in which long-only, passive asset-class beta had materially outperformed factors, the last six months have seen an abrupt reversal. We never bought into the notion that factors had been “arbitraged out,” or somehow were no longer of importance, but we have acknowledged that they can be less effective for long periods. We make the case that factors remain an important part of strategic allocation—both from return and diversification perspectives.

The conclusions of this note can be outlined as:

  • The trade into private assets has further to go.
  • The case against bonds is less strong but based on our inflation outlook, many investors still need a higher real return. Wider spreads could make credit more attractive—especially for income-focused investors—if recession can be avoided. However, spreads don’t currently reflect a full recession, and we believe that high-grade bonds are less effective diversifiers than in the past.
  • Investors still should hold more exposure to real assets in their strategic allocations, and factors have an important role to play in portfolios.
  • Neither equity investors nor sell-side analysts have capitulated. This constitutes something of an overhanging tactical risk for the equity market. Having said that, sentiment signals have moved to a muted level, offering some tentative support. Beyond that tactical risk of potential downgrades and outflows, there is a strategic case for positive real equity returns.

Is the Trade into Private Assets Done?

The shift from public to private assets has been a dominant allocation theme over the past decade. In recent weeks, some have argued that the abrupt downward adjustment in the valuations of public markets (and yield increase) removes the need for that shift. We disagree. To claim that the recent fall in markets obviates the need for private asset exposure either displays too much recency bias or denies that the post-pandemic world is different. We think there’s still a need to increase allocations to private assets, but we do think future marginal flows will head to areas that have lagged.

In previous research, Private Assets and the Future of Asset Allocation, we’ve pointed out that there are multiple reasons to shift to private markets:

  1. A perceived lack of return in public markets
  2. A need to find sources of diversification
  3. Private markets are part of protecting portfolios against inflation
  4. A dearth of young high-growth companies that choose to list on public markets

How do these reasons stack up after the tumultuous first half of 2022? The expected returns on public equities and fixed income are higher than they were on January 1 (note: we’re commenting on the strategic view over several years, not tactical). Still, the long-run context implies lower returns than have been the norm in recent decades, so there’s still the need to fill a return gap.

For the other three reasons, if anything, the need for private assets is even greater. As we pointed out recently, we expect both the level and volatility of inflation to be elevated for a prolonged period, so investors can’t take the mutually diversifying properties of stocks and bonds for granted. If bonds are less effective at diversifying equity risk than in recent decades, investors must find additional diversification sources.

Some of the diversification offered by private assets is merely a function of the lack of live prices, and hence, is of dubious efficacy. Having said that, there’s also a genuine element of diversification in private returns.

If we’ve learned anything in the last six months, it’s that the need to protect portfolios against inflation is urgent. Private assets have no unique claim to offer this protection, but multiple private return streams play important roles. We’ve pointed out before that what one means by inflation protection depends on one’s time horizon. Investors with short horizons need assets that have a higher beta to inflation, such as commodities or explicit inflation-protected instruments. However, for investors with longer time horizons, we suggest that the key criterion is to find assets that continue generating positive real returns when inflation is elevated, such as real estate, infrastructure and farmland, among others.

We also note that the fourth reason—the dearth of new public listings compared with one or two decades ago—remains. Thus, earning the equity risk premium requires a larger default level of private assets than in earlier decades.

In Display 1, we show the trade-off between nominal net return (or cost, if the number is negative) and correlation with equities. Over the past three decades, high-grade bonds occupied a unique place in the upper-left quadrant—offering positive returns and diversification. The abrupt upward shift in yields over the past six months has improved the return potential from high-grade bonds and will probably push it into positive real return territory over the next decade. However, this shift must be seen in context of the range of other return streams available. It’s apparent from the chart that there’s a “frontier” of assets with different trade-offs between return and diversification. No large asset class offers the very attractive prospect of positive return and deeply negative correlation with equities, suggesting that investors need to tap into a range of assets along the frontier.

We’ve long been skeptical about expected returns on private equity; we expect the average return on the average private equity investment to be in line with public equities after fees. Even after applying a significant return haircut to private equity, private assets such as real estate, private debt and farmland are candidates for significant portfolio allocations. Also, there are other potentially helpful return streams in the liquid alternative space, such as factor strategies (both long-only and long-short).

Display 1: Net Return vs. Correlation with US Equities
Display 1: Net Return vs. Correlation with US Equities

Historical analysis and current estimates do not guarantee future results.
Note: The chart uses monthly data since 1990. Private equity, private debt, farmland and timberland series are quarterly, and we match the drawdown periods to the nearest quarter.  We assume a 10 basis point (b.p.) fee for US 10-year bonds, gold, REITs, TIPS and high-yield bonds. We assume a 20 basis point (b.p.) fee for long-only factors and a 50 basis point (b.p.) fee for long/short factors. For timberland, farmland and private debt, we assume a 150 basis point (b.p.) fee. Multi-asset trend strategy is based on 12-month momentum across equities, fixed income, FX and commodities, implemented through most liquid futures contracts with a 12% annualized volatility target. To calculate annualized return for this strategy, we add back the annualized three-month Treasury bill return and subtract a basis point (b.p.) fee.
January 31, 1990, through December 31, 2021
Source: Bloomberg, Cambridge Associates, Cliffwater, Global Financial Data, National Council of Real Estate Investment Fiduciaries (NCREIF), Thomson Reuters Datastream and AB

Bonds Are Back?

An often-heard phrase in recent weeks is that “bonds are back.” The sentiment reflects the upward shift in yields—long-term investors entering a high-grade fixed-income position, in the US at least, can now expect to achieve a positive real return over the next decade.

This is a significant change that lessens the case against fixed income in absolute terms. Indeed, with US investment-grade credit yielding close to 5%, it’s not far below the expected return on equities. Meanwhile, the prospect of not losing money in real terms on US government bonds indubitably makes the case for bonds better than it was. A positive real yield will likely attract more investors, or at least slow decisions to reduce bond allocations.

However, we also must view this in the broader context of all potential sources of return. In other words, the absolute case for bonds has clearly improved; the open question is whether the relative cross-asset case has shifted enough. On this point, investors with different constraints may come to different conclusions. The issue arises for investors requiring a long-term positive real return, given our view on higher equilibrium inflation. For such investors, we still see a strategic case against fixed income—though less strong than six months ago. We acknowledge the clear role for bonds as drawdown protection, a role that no longer imposes a cost in real terms.

There’s also an improved case for credit, suggesting something closer to a neutral position than an underweight. A positive tactical case for credit rests on the increase in yields so far this year. In Display 2, we show the yield spread of US investment-grade credit over the equity dividend yield overlaid with six-month forward relative returns. If the history of the past decade is a guide, then at face value, it’s implied that the credit-yield/dividend-yield spread is large enough to support a tactical pro-credit position—even relative to equities.

Display 2: Credit-Dividend Yield Spread and Forward Returns
Display 2: Credit-Dividend Yield Spread and Forward Returns

Historical analysis and current estimates do not guarantee future results.
March 15, 2013, through June 24, 2022
Source: Bloomberg, National Bureau of Economic Research (NBER) and AB

However, there are caveats to this conclusion. Except for the pandemic, this period does not include an outright recession. We think a more relevant context would look back over a longer period that includes several previous recessions. In Display 3, we show a similar chart with the spread of the BAA credit yield over dividend yield. We mark previous pre-recessionary peaks, as determined by the National Bureau of Economic Research. For the recessions of 1990, 2001 and 2007, credit performed at least in line with equities or outperformed, but from starting yield spreads 350 basis points higher than today’s.

Display 3: Credit-Dividend Yield Spread and Forward Returns (with Recessions)
Display 3: Credit-Dividend Yield Spread and Forward Returns (with Recessions)

Historical analysis and current estimates do not guarantee future results.
DY: Dividend Yield
IG: Investment Grade
August 31, 1988, through July 1, 2022
Source: Bloomberg, NBER, S&P and AB

With their recent climb, investment-grade credit spreads over US Treasuries are above the median non-recessionary level (Display 4). If the current slowdown avoids transitioning to a recession, the current credit yield could prove attractive—especially for investors focused on income rather than total return. However, investors must acknowledge that if a recession does happen, one should anticipate a further widening of credit spreads. Current spreads are not pricing in a recession. The increased attractiveness of current yields seems more to do with the move in US Treasury yields than the way the market has priced credit risk.

Display 4: Investment-Grade Credit Spreads over Treasuries and Recessions
Display 4: Investment-Grade Credit Spreads over Treasuries and Recessions

Historical analysis and current estimates do not guarantee future results.
January 31, 1997, through June 30, 2022
Source: Bloomberg, NBER and AB

What about the perspective over more strategic horizons? In Display 5, we show real returns over the past decade for a range of assets, as well as our view of their likely return over the next decade. Even with the outlook improved from starting levels a year ago, the return is still lower than investors have become accustomed to. For many investors, we think this still leaves an uncomfortable conclusion: to achieve a given level of real return, they may need to increase risk.

Display 5: Our Outlook for Markets and Alpha Points to the Need to Change the Building Blocks of Strategic Asset Allocation
Investors Must Add Risk; Pension Plans May Need to Add Factors
Display 5: Our Outlook for Markets and Alpha Points to the Need to Change the Building Blocks of Strategic Asset Allocation

Historical analysis and current estimates do not guarantee future results.
The dots represent the last 10 years of real returns and volatility for the major return streams that investors can buy. The arrows represent the AB Institutional Solutions team's forecasts for the next 5–10 years. Note: The US Private Equity data are compiled from 1,562 funds, including fully liquidated partnerships, formed between 1986 and 2019. All returns are net of fees, expenses and carried interest. Data are provided at no cost to managers.
As of September 22, 2021
Source: Cambridge Associates, FactSet, Federal Reserve Economic Data, Kenneth R. French Data Library, Thomson Reuters Datastream and AB

This conclusion has different relevance for different kinds of investors. Some long-horizon asset owners, including some pension funds and sovereign wealth funds, have stated their target in terms of a real return over inflation. For these investors, there are two overt problems with the “bonds are back” narrative: 1) even after generally high returns in recent years, many investors can’t afford a period of low returns, and 2) bonds may not play the same diversifying role in the future as they have in past decades.

Let’s tackle the return problem first. Many asset owners need to deliver returns that are set in real terms. This is because the underlying reason for the investment is to cover liabilities or goals set in the real economy—this applies to sovereign wealth funds, endowments and individuals saving for retirement. We note that in some cases this need for a real return might not be explicit—as for the last 30 years, financial asset returns have strongly outstripped inflation. That does not avoid the observation that many such return targets should be couched in real terms.

As an aside, many US pension plans target a return in the region of 7%, in nominal terms. We’ve long questioned the ability to achieve such a return. Higher inflation could theoretically make it easier to achieve such a target, but we think it would come at the expense of a larger problem: in an environment where inflation is expected to remain high, a nominal return target might become insufficient. However, we fully recognize that this is likely to be more of a sociopolitical question than one that keeps pension plan CIOs awake at night.

In Display 6, we show the returns from a broad set of target-date funds for the 2030 cohort relative to an assumed required glide path. Even several years of healthy returns have not obviated the need to generate high returns from here.

Display 6: Actual and Theoretical Pension Pot for 2030 Retirement Cohort 2030 Target-Date Funds
2030 Target-Date Funds
Display 6: Actual and Theoretical Pension Pot for 2030 Retirement Cohort 2030 Target-Date Funds

Historical analysis and current estimates do not guarantee future results.
The chart shows the theoretical size of the savings pot for a person who saves 5% of his salary every year and, on average,  achieves 7% return on investment vs. the actual achieved return by the 2030 target-date fund cohort. Sample period 1985–2021. For 2022, we pro-date the returns with a US 60/40 portfolio return year to date.
January 1, 1985, through June 30, 2022
Source: eVestment and AB

As we show in Display 7, the 2040 cohort faces the same predicament.

Display 7: Actual and Theoretical Pension Pot for 2040 Retirement Cohort
2040 Target-Date Funds
Display 7: Actual and Theoretical Pension Pot for 2040 Retirement Cohort

Historical analysis and current estimates do not guarantee future results.
The chart shows the theoretical size of the savings pot for a person who saves 5% of his salary every year and on average achieves 7% return on investment vs. the actual achieved return by the 2040 target-date fund cohort. Sample period 1985–2021. For 2022, we pro-date the returns with a US 60/40 portfolio return year to date.
January 1, 1985, through June 30, 2022
Source: eVestment and AB

In a similar vein (Display 8), we show the rolling 10-year return from a US 60/40 strategy versus US inflation. The 60/40 has delivered compelling returns since 1980, especially for investors saving to cover liabilities established in the real economy (in other words, with an implicit inflation benchmark). Now, however, the decline in 60/40 returns and rise in inflation has closed this gap, as it had many times before the past 40 years.

The dangers of 60/40 strategies have been well-flagged, and many investors have moved away from such a model. However, it still holds sway as a benchmark, and many investment strategies continue to cling to it. A 60/40 strategy using US equities and 10-year Treasury bonds would have lost 16% since the start of 2022—one of the worst losses since the 60/40 became popular in the early 1980s. We’ve long argued that this approach to investing is far from being default or “passive.”

The recent fall may not be cathartic. In fact, it may foreshadow what’s to come, given the potential structural increase in the volatility of such a strategy if the stock-bond correlation increases. After a decline like we’ve seen, investors in a 60/40 may be unable to accept low returns if their ultimate benchmark is to fund needs tied to the real economy—such as retirement.

Display 8: Returns from 60/40 and Inflation (US)
Display 8: Returns from 60/40 and Inflation (US)

Historical analysis and current estimates do not guarantee future results.
January 1, 1920, through May 31, 2022
Source: Global Financial Data, Thomson Reuters Datastream and AB

The second problem for investors with the generalized “bonds are back” narrative is the potential that the stock-bond correlation doesn’t return to its deeply negative levels of recent years. We think the last couple of decades that saw a deeply negative stock-bond correlation must be seen as an aberration in the longer sweep of history.

Another problem in the background, though admittedly not on the radar of most CIOs, is our assertion that there’s no such thing as a risk-free rate anymore. This assertion is based on the observation that the existence of real risk-free assets is contingent, not a given.1 Also, higher debt/GDP ratios are in line with those last seen at the end of WWII with no obvious path out through growth, so investors must at least consider the risk of currency debasement.

Despite the recent concurrent losses from both equities and bonds, there’s still a crucial role for high-grade fixed income in reducing short-term drawdowns and controlling overall risk levels, because many “fixed-income replacements” proposed in recent years have been more volatile. In Display 9, we show the trade-off between the return (or cost) of holding a strategy and its performance in past equity drawdowns over the past 30 years. High-grade bonds occupied an enviable position, tending to offer positive returns in a drawdown and a positive overall return. Six months ago, they faced the prospect of being a net drag on a portfolio; at today’s yields, they offer potential drawdown protection and at least a slight positive return.

Display 9: Net Return vs. Equity Drawdown Protection
Display 9: Net Return vs. Equity Drawdown Protection

Historical analysis and current estimates do not guarantee future results. 
The chart uses monthly data since 1990. Private equity, private debt, farmland and timberland series are quarterly, and we match the drawdown periods to the nearest quarter. We assume a 10 b.p. fee for US 10-year bond, gold, REITs, TIPS and high-yield bonds. We assume a 20 b.p. fee for long-only factors and a 50 b.p. fee for long/short factors. For timberland, farmland and private debt, we assume a 150 b.p. fee. The option strategies are shown for on-year 15-delta puts, market-cap weighted and delta-hedged daily. Multi-asset strategy is based on 12-month momentum across equities, fixed income, FX and commodities, implemented through most liquid futures contracts with a 12% annualized volatility target. To calculate annualized return for this strategy, we add back the annualized three-month Treasury bill return and subtract a 200 b.p. fee.
Drawdown periods include December 1999 to March 2000, September 2000 to September 2002, September 2007 to March 2009, March 2011 to September 2011, March 2012 to June 2012, June 2015 to September 2015, September 2018 to December 2018, March 2019 to June 2019, December 2019 to March 2020 and September 2020 to December 2020
January 31, 1990, through December 31, 2021
Source: Bloomberg, Cambridge Associates, Cliffwater, Global Financial Data, NCREIF, Thomson Reuters Datastream and AB

In summary, the case against fixed income is not as strong as it was six months ago. If one assumes that a more prolonged slowdown is upon us and that credit spreads would typically widen further, high-grade bonds offer drawdown mitigation and a slight positive real return, which is useful in the portfolio context. We worry that for many investors who need to beat inflation, that return might not be enough. For those who don’t have inflation as a benchmark (insurers, for example), this is less of a constraint.

Is the Trade into Real Assets Over?

Another strategic question is: Have the exceptionally good returns for real assets closed the case for increasing real asset exposure? We think the answer is no. That answer depends somewhat on what one means by a real asset, because overall returns are very skewed by commodities and power prices (Display 10). Casting the net more widely, returns in recent months have been less exceptional, though still markedly better than core financial assets—public equities and bonds. Given the higher probability of a recession, the case for a large weight in commodities after such a strong run may indeed be more muted: one, two and five years after the start of a recession, commodities have tended to lag stocks. However, other real assets haven’t shared in commodities’ sharp run-up.

Display 10: Recent Performance of Real Assets Is Skewed
Display 10: Recent Performance of Real Assets Is Skewed

Historical analysis and current estimates do not guarantee future results.
Renewable power delivery returns are based on German Spot power price index. Infrastructure returns are based on an index of publicly listed infrastructure companies.
June 30, 2021, through June 22, 2022
Source: Bloomberg, NCREIF, Thomson Reuters Datastream and AB

In Display 11, we update our chart of the longer-run performance of financial assets versus real assets. The recent underperformance of financial assets is significant, but still within the bounds of the past decade. What’s more, our need to have a long time series for this chart means that financial assets have a large weight in commodities—not the broader set of real assets outlined above.

Several factors imply that this readjustment isn’t yet finished. The equilibrium level of inflation is likely higher and starting yield levels remain low in a historical context. There’s also the likelihood that questions of social fairness and wealth distribution persist.

Display 11: Financial Asset vs. Real Asset Performance
Display 11: Financial Asset vs. Real Asset Performance

Historical analysis and current estimates do not guarantee future results.
Financial assets include US Equities and US 10-year government bonds. Real assets include US Real Estate and Bloomberg Commodities indices.
February 1, 1953, through May 31, 2022
Source: Bloomberg, Global Financial Data, Robert Shiller's database and Thomson Reuters Datastream

We can go beyond the recent performance data and make a more normative statement: the fundamental reason why the real asset trade has further to go is that investors need it. In earlier research, we distinguished different kinds of inflation hedges. Investors with short time horizons need to defend against inflation by allocating to assets that have high betas to inflation.

Investors with a longer investment horizon, by contrast, should define an inflation hedge differently. For them, we think the metric should assess which instruments generate a positive real return during a period of higher inflation. As we outlined in our research on defending portfolios against inflation, we think equities are a core anchor and can count as a real asset. We also think a range of other real assets are needed, including renewable power delivery, infrastructure, real estate, farmland and private debt. Factor strategies, such as value, can be part of this mix. We discuss these next.

Factors Are Back!

Investors should see portfolios as a combination of return streams. At its most basic level, that’s what constitutes investing. Whether return streams are asset classes, an individual physical asset or a factor strategy is of secondary importance.

Following this logic, we’ve made the case to investors for several years that factors should be an important part of asset allocation and viewed, with some limits, as being fungible with asset classes. This strategic case is distinct from the question of whether investors can effectively time factors; instead, the strategic case is that factors may help from both a return perspective (Display 12) and as a source of diversification.

Based on our own experience from client meetings in recent years, we understand that it has been hard to market that story when factors had not fared well, even if investors could see the case in principle. We never bought into the notion that factors had been “arbitraged out” by an inflow of capital,2 but we have acknowledged that factors can be less effective for long periods (Display 12). The past year has witnessed a significant rebound in factors’ efficacy. The changing fortune of the value factor is part of that, but momentum and quality have also delivered positive returns since mid-2021 in the US. The recent effectiveness of factors sharply contrasts with stocks and bonds.

Display 12: Aggregate Factor Risk-Adjusted Returns by Region
Based on Five-Year Trailing Annualized Return/Risk
Display 12: Aggregate Factor Risk-Adjusted Returns by Region

Historical analysis and current estimates do not guarantee future results.
Chart shows the five-year annualized return/risk ratios averaged for seven factors—price to book, dividend yield, return on equity, long-term growth, price momentum, small-cap and free-cash-flow yield—in each region. Baskets are rebalanced quarterly, and we use total long-short USD returns. 
December 31, 1994, through May 31, 2022
Source: FactSet,  Institutional Brokers' Estimate System and AB

Why should an investor believe that factors can remain effective? The recent performance turn will likely convince more investors that the subpar factor performance in recent years was cyclical rather than structural. This point is important because it would break the narrative that factors somehow didn’t matter or were inappropriate as an explicit element of an allocation decision.

Beyond the general case for factors, there are reasons to make a case for specific factors. Value in particular stands out here. For the past 100 years (Display 13), there’s been a link between the efficacy of value and inflation. In periods of elevated inflation, value tends to fare better, while being less effective in lower-inflation environments. This relationship implies that at least some of value’s underperformance in the decade preceding the past 12 months stemmed from the persistent undershooting of inflation relative to expectations.

Display 13: The Efficacy of Value Is Linked to Inflation
Display 13: The Efficacy of Value Is Linked to Inflation

Historical analysis and current estimates do not guarantee future results.
January 1, 1936, through March 31, 2022
Source: Kenneth R. French Data Library, Thomson Reuters Datastream and AB

One shouldn’t be too rosy-eyed about this analysis because inflation is clearly not the sole factor determining the efficacy of the value factor. Two structural headwinds to value remain in place. Technological innovation has destroyed protective “moats” around some industries, which has impeded mean reversion as a signal. An industry that’s very cheap historically may actually be at the losing end of a break in traditional competitive dynamics rather than simply being underappreciated cyclically. Also, over the past decade, corporate investment’s primary focus has switched from tangible to intangible assets. Different accounting treatments raise key questions about measuring value. These forces still stand, so one should not expect traditional value definitions to perform in line with their longer history.

We’ve also drawn a distinction in previous research (Asset Classes and Factors: What’s the Difference?) between stocks in a value trade: those that perform well as a direct function of inflation versus those that shine by the indirect mechanism of benefiting from the usual central bank inflation response—banks in particular. At the moment, both parts of that value trade can do well, but over longer strategic horizons, we’re less sure about the second group.

Other factors beyond value can do well: low volatility stands out. This factor tends to suffer when inflation expectations rise quickly, which happened last year. However, we can show that in the main episodes since the 1970s, when inflation expectations peaked and then subsided or stayed in a range, low volatility’s risk-adjusted performance fares well versus both equities and 60/40 strategies.

Another factor that stands out from a strategic perspective is quality, with higher-quality stocks tending to deliver attractive risk-adjusted returns over longer horizons. Finally, there’s momentum. It’s hard, in a sense, to have a fundamental strategic view on momentum. It’s the most chameleon-like of factors, given its rapidly changing composition. Having said that, it has a role as part of a broader allocation, especially when price trends can become established and entrenched, as happens in some inflationary periods. Thus, momentum has a role to play in inflation protection.

The case for factors is not, however, only about their ability to plug the “return gap” between what investors require and what is available. Factors also have a role in portfolio risk-control. We have shown in Asset Classes and Factors: What’s the Difference? that factors have a long history of providing more consistent diversification than asset classes. The average pairwise correlation of factors is more stable than the average pairwise correlation of asset classes.

The Impact of an Economic Slowdown…and What it Means for Equities

Recessions…and the Equity Outlook

We end this note with a more explicit look at the equity outlook in the light of the higher probability of recession in the US and Europe. We don’t wish to get too hung up about whether there’s technically a recession or not. After all, one only finds out the answer after the fact. But what’s the normal response to a slowdown?

Display 14 shows how different assets have performed in periods after the US Composite Leading Indicator (CLI) first signals a “recession.” In this case, the recession signal is triggered when the indicator is below 100 and the month-over-month change is negative. The starting period is January 1974, and we only consider periods where the recession signal lasted at least six months. This analysis tends to signal more recessions than actually happened, but that construct is probably appropriate given the stage we’re at today. The US CLI crossed into recession territory at the end of March 2022, signaling that we’re still in the early stages of economic slowdown based on that informal definition.

People have often asked us over the past three years what the business cycle implied for asset-class returns. Our reply was a denial—not entirely tongue-in-cheek—that a business cycle exists anymore. The pandemic and the fiscal response swamped such a categorization. We now think that there’s a good claim to be made that the business cycle is back, at least outside China. The business-cycle prognosis can only be part of the picture, because valuations, sentiment and investor needs also factor in.

But leaving those other aspects to one side for now, what does the beginning of a slowdown portend for entry points to strategic trades? As the analysis shows, over periods of 12 months or longer from the starts of recession signals, median returns have been supportive for equities globally (US in particular), real estate investment trusts and commodities. From a factor perspective, FX value, low beta, quality and equity momentum also outperformed historically.

Display 14: Median Total Return from the Start of “Recession” Signal from US Composite Leading Indicator
Display 14: Median Total Return from the Start of “Recession” Signal from US Composite Leading Indicator

Historical analysis and current estimates do not guarantee future results.
The chart shows forward returns from six months to five years forward for various assets, starting from the first time the US OECD Composite Leading Indicator signals a recession, which is defined as a CLI level below 100 and negative month-on-month change. The time horizon for the analysis is from January 1974 to May 2022, and we only consider periods where the CLI recession signal was at least six months.
January 1, 1974, through May 31, 2022
Source: AQR Capital Management , Bloomberg, FactSet, Global Financial Data, Kenneth R. French Data Library, OECD, Thomson Reuters Datastream and AB

Another lens for viewing return prospects is to see what valuations are suggesting (Display 15). Current forward price-to-earnings (P/E) ratios for the US and Europe already appear to be at recessionary levels (see area highlighted in the blue outline).

Display 15: Equities Pricing a Recession Already?
Display 15: Equities Pricing a Recession Already?

Historical analysis and current estimates do not guarantee future results.
Economic cycles are defined based on the level and change in the level of  the US and European OECD leading indicators: below 99 and increasing = recovery, above 99 and increasing = expansion, above 99 and decreasing = slowdown, below 99 and decreasing = recession.
As of June 31, 2022
Source: Bernstein Research

That valuation level might appear encouraging, but there’s a peculiar feature of this particular market: neither asset owners nor sell-side analysts have capitulated yet. Consensus earnings-per-share (EPS) growth forecasts for 2022 and 2023 haven’t been cut meaningfully. For the US, they stand at 9.6% for 2022 and 10% for 2023; for Europe, they’re 13.8% and 3.6% respectively. This situation leaves a legitimate worry that these headline P/E multiples could be low estimates.

Likewise, we’ve yet to see meaningful outflows from risk assets, such as equities. This lack of capitulation on the part of sell-side analysts and asset owners is the most significant tactical worry for the tactical equity outlook. It constitutes an overhang risk.

It is possible, though, that an exodus of capital need not happen. We’ve been pointing out that investors need a meaningful, strategic equity allocation, given that it’s the largest real asset, to defend against higher-equilibrium inflation. And the rapid retreat from buying has pushed our fund-flow sentiment indicator (Display 16) to one of its lowest levels in decades—usually a supportive sign for markets. Likewise, net equity issuance by corporations has rapidly retreated, again usually a helpful sign for markets over the next year (Display 17).

Display 16: Global Fund-Flow Sentiment Indicator
Display 16: Global Fund-Flow Sentiment Indicator

Historical analysis and current estimates do not guarantee future results.
July 7, 2004, through June 29, 2022
Source: Emerging Portfolio Fund Research Global and AB

Display 17: Global Net Issuance Indicator
Display 17: Global Net Issuance Indicator

Historical analysis and current estimates do not guarantee future results.
Our net issuance indicator is constructed from 12-month sum of equity issuance announcements minus 12-month sum of stock buybacks and is shown as a percentage of the Thomson Reuters Datastream world index market cap. The blue line is 12-month forward equity market returns and is shown on the right-hand inverted axis.
January 1, 1995, through April 30, 2021
Source: Bernstein Research Portfolio Strategy, Bloomberg, Thomson Reuters Datastream and AB

One arguably simplistic way to estimate long-run equity returns is to assume that valuation ultimately reverts to its historical average. Our preferred valuation metric for the US market is the Shiller PE ratio. Comparing the Shiller PE to 10-year forward US equity returns (Display 18) suggests medium-term US nominal equity returns in the region of 4% per year.

However, this assessment assumes a reversion to the long-term mean. We think this likely underestimates equity returns, because there is a good case that real yields will stay below long-run averages. Yes, they’ve risen a lot recently, but they’re still low in the longer sweep of history. Given that, and the balancing deflationary and inflationary forces over strategic horizons, we argue that lower-than-average real yields support higher-than-average multiples.

Display 18: US Shiller PE Ratio and 10-Year Forward Equity Returns
Display 18: US Shiller PE Ratio and 10-Year Forward Equity Returns

Historical analysis and current estimates do not guarantee future results.
*Cyclically adjusted price to earnings. Shiller PE defined as price divided by 10-year average inflation-adjusted earnings.
January 31, 1881, through June 30, 2022
Source: Global Financial Data, Robert Shiller's database and AB

We can also assess equity return potential by decomposing the key drivers of real equity returns over the medium term, which can be expressed as:

Real equity return = dividend yield + buyback yield + real growth per capita + population growth + change in profit share of GDP + multiple expansion/contraction

The current dividend yield is 1.6%, and the buyback yield over the past 10 years averaged 1.7%. Long-term real GDP growth per capita is 1.5% annualized, and the long-run US population growth estimate from the United Nations is 0.5% annualized. Here we are assuming that productivity remains constant, as it has proven very difficult for investors to forecast strategic shifts in productivity and an outlook that relied on such a forecast would be questionable. We think the profit share of GDP will shrink: US corporations have recently been taking an unusually large share of national output in the longer-run context, which we don’t think is sustainable. We’ve estimated the change from a forecast of US nonfinancial corporate profit margins.

We assume that revenue grows in line with the trailing five-year average, that the employee-compensation share of GDP and inventory share of GDP return to pre-2000 averages, and that the effective corporate tax rate is 20%. We also assume no multiple contraction, given our case for real yields remaining close to today’s levels. While real rates have risen sharply in the past few months, we expect them to remain significantly below their historical average in the coming years, which should support the equity market valuation multiple.

Bringing all these inputs together, we get:

Real equity return = 1.6% + 1.7% + 1.5% + 0.5% – 1.8% = 3.5%

This equation suggests real equity returns of 3.5% per year. The US 10-year breakeven inflation rate is 2.5%, which would equate to a nominal return of around 6% per year. This would be below the levels investors have become accustomed to but would still leave equities as a core portfolio component for investors seeking to beat inflation.

Conclusion

This note is intended to guide the conversation on strategic asset allocation in the light of recent market moves. Some investors revisit their strategic allocations on a slow-moving, preset cycle, but we’d argue that the scale of the changes warrants a faster response than those time frames.

Central banks have become more overtly hawkish than we expected six months ago. However, we think the strategic expectation that macro forces keep inflation above pre-pandemic levels still stands. This is a longer-term statement than the current rate-hike cycle. In recent months, expected long-term forward returns for stocks, credit and bonds have shifted up, distinct from the tactical outlook.

Investors needing to generate real returns—endowments, sovereign wealth funds and defined-contribution pensions, for example—still need significant real asset exposure. We argue that public equities need to be a large part of this mix, given their size and liquidity. The prognosis for equity returns, while muted relative to history, remains favorable versus other sources of real return.

We also argue that these investors still need to increase exposure to a range of other real and private assets such as real estate, infrastructure and renewable power. In the context of private assets, we think marginal flows from here will be headed more into areas distinct from private equity. We also think that investors focused on real returns can use allocations to factors such as value and low volatility as a tool to address the combined challenge of defending against inflation and meeting return/risk requirements.

The conclusions are different for asset owners with nominal-return requirements, such as insurance companies or other fixed-income investors. For these asset owners, the sharp surge in bond yields and improved case for bonds in absolute terms enables a higher return per unit of risk, alleviating much of the challenge of designing a strategic allocation in recent years.

For the industry overall, the market decline and correlation increase of early 2022 has been painful, and it will have changed assumptions about tactical and strategic returns. The macro context still implies that the rotation into private and real assets, along with factors, has further to go. However, there are more investment options in public markets, and some areas of private markets have seen capital build up too rapidly. Forming an allocation across these different types of return streams is a key challenge for investors, given the market’s recent turbulence.

1Global Quantitative Strategy: The end of Pax Americana and what it means for the market, Bernstein Research, January 23, 2019.
2Global Quantitative Strategy: Are factor premia disappearing?, Bernstein Research, November 6, 2017.

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