The global economy is unlikely to return to the same low inflation regime seen before the pandemic, and this scenario will have long-lasting implications for asset-class dynamics and asset allocation over the next 10 years, according to a new report.
Structural inflation is estimated to reach a long-term annual average of 2.8% in the United States (compared with 1.8% in the years before Covid-19) and 1.9% in the euro area (versus 1.4% prior to the pandemic), Pictet Wealth Management says in the 2022 edition of Horizon, its 10-year view on economies.
It cites five factors for this scenario: demographic shifts; the fading of the current innovation wave’s disinflationary effects; changing economic models in emerging countries, mainly China; the trend towards deglobalization under the aegis of increased state intervention; and the return of big government as the fight against negative externalities picks up.
The report also sees a structural increase in the direct cost of energy as well as in indirect costs such as carbon pricing and other government incentives to reduce dependence on fossil fuels.
At the same time, trade tariffs imposed by the US on imports from China since 2018, the war in Ukraine, and high transport costs could increase the trend towards reshoring to limit the vulnerability of supply chains.
“Any regime shift toward higher long-term inflation would have deep and long-lasting implications for asset-class dynamics and strategic asset allocation,” says Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. “Investors relying on sources of fixed income could be hit especially hard. Higher long-term inflation would have consequences for monetary policy. It could also put financial stability at risk, since higher inflation tends to increase the volatility both of macroeconomic data and of the policy response.”
Ducrozet expects annual average returns in the next decade for the vast majority of asset classes to be lower than in previous decades, adding that returns will be particularly low for cash, core sovereign bonds and other so-called “safe haven” asset classes.
“Investors who choose to stay strategically invested in safe-haven assets will have to bear a particularly severe erosion of capital – possibly by as much as a fifth of these assets’ initial value,” he says.
Equities will deliver a 5–6% annual return in nominal terms, compared with over 9% in the previous four decades. Pictet Wealth Management expects emerging-market stocks to do better than their developed-market counterparts, with the MSCI Emerging Market Index yielding an average annual return of 7.5% over the next 10 years, compared with an average of 10.5% since inception in 1987.
The report says Chinese equities are unavoidable in view of the unparalleled size and depth of the market, as well as China’s economic and political clout. It expects Chinese equities to deliver an average return of 7.5% per annum, slightly higher than last year.
“While economic growth has undoubtedly slowed since last year’s projections because of the travails of China’s real estate sector, growth remains high by developed-markets standards, hence supporting companies’ top-line projections. In addition, we expect the renminbi to appreciate over time against the USD, hence providing some support to returns in hard currency terms.
Higher bond yields
In the fixed-income space, Pictet Wealth Management forecasts wider spreads and higher yields for government bonds. Still, it expects global government bonds to deliver an average annual return of just 1.3% and global investment-grade (IG) corporate bonds of just 3.2% and 3.9% for high yield (HY).
The firm sees the highest returns to come from Asian high yield. It expects EM corporate debt in general to produce an annual average total return of 4.5% over the next 10 years. Asian (ex-Japan) IG debt is forecast to deliver an average annual return of 4.6% in US dollars, with riskier Asian (ex-Japan) HY delivering 6.8%.
According to the report, China (including Hong Kong) continues to dominate Asian (ex-Japan) corporate bond indices and issuance, accounting for about 54% of Asian corporate bonds outstanding. This dominance may grow further in the years ahead, it says.
Real assets and private equity should continue to deliver superior returns, but annual returns will not reach double digits. While private equity has historically posted a 15% annual return, for example, Pictet expects it to deliver "only" 9.2% in the next 10 years. It cites three main reasons for the decline: valuations are high, funding costs will increase, and private equity is becoming an overcrowded asset class.