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Written by: Richard Flax
28/04/2022
The Covid pandemic, inflation and war have created a challenging start to 2022. For long-term investors, where can they seek returns?

The unique situation created by the Covid-19 pandemic has meant that we’ve experienced in just a couple of years an economic cycle of recession and recovery that would normally last much longer.

Inflation is at its highest rate in thirty years and is not predicted to fall back until 2024. The shocking humanitarian crisis unfolding in Ukraine is also having an economic impact in the form of hindering economic growth and creating higher, more sustained inflation.

Given this, what is the outlook for long-term returns?

The below chart looks at forecast annualised returns over ten years (run as of April 2022):

Nominal government bonds

Starting yields are now some way higher than last year, meaning global fixed income returns have improved a bit through their carry component.

When the starting yield is low, investors are more at risk of having capital losses as rates increase, not compensated by any significant coupon in the foreseeable future. We believe that central banks may have generally left interest rate hikes a bit late, and as a result we may see rate increases continue beyond 2022 in order to bring down inflation.

Inflation-linked government bonds

Relative attractiveness of these bonds can be estimated through the so-called break-even rate, i.e. the level of inflation which makes the nominal bond yields equal to the real ones. If the inflation achieved is higher than the break-even level, the yield of the index bond will be higher than that of the respective nominal bond. Given these instruments are correlated with inflation, ‘linkers’, as they are known, tend to provide less diversification compared to nominal bonds.

The rise in nominal rates is inevitably bad for bond prices. However, whether linkers can outperform nominals is all dependent on how effective monetary policy is at curbing these high levels of inflation. Given the changes in expectations for monetary tightening, we believe that investors may now even be overestimating in some cases the scale of monetary policy tightening that will be required to bring down inflation. Therefore, expected returns for linkers are now a bit lower than nominals in this framework.

From the point of view of risk management, it’s important to consider the ability of these investments/assets to offer protection from sudden and unexpected price increases; giving up some of the return for greater protection could be a justifiable choice.

Corporate bonds and sovereign emerging markets’ debt

As sovereign yields are up slightly, yields to maturity on risky bonds this year are higher than last year. Interest rates are still relatively low from a historic perspective and, as such, the risk-free component linked to government bonds dampens the long-term perspective for this asset class.

From a relative value stand-point, we see a good risk return trade-off in emerging bonds and global investment grade over global high yields, with the implied default rate from current spreads implying a much higher default rate than the actual historical default rate for these securities.

Equities

Like previous years, equity valuations are relatively high, particularly in the US where multiples have continued to expand at a fast rate, meaning US equities are looking particularly expensive.

UK and European Equities look more appealing as they are closer to historical valuations – the UK in particular, which offers the highest historical dividend yield. Despite Japan also looking cheap relative to the US, we assume lower growth than for the rest of the world, meaning it also points to a region of disappointing returns.

The expected return for Emerging markets has improved on last year based on solid long-term earnings growth and again, cheaper looking valuations relative to the US in particular.

Equity is also an asset class capable of protecting investors from long-term inflation. We believe it holds an important place in the portfolio beyond providing historically high returns.

Commodities

Commodities are a fairly volatile asset class, since the main global indexes are composed primarily of energy, grains and metals. Several of these commodities see their prices go up and down due to supply and demand imbalances that can be affected by monopoly decisions, regulation and the severity of winter.

For a few years, commodities have underperformed against other risky assets. However, through Moneyfarm’s strategic asset allocation approach, which we undertake each year, we started seeing positive signals at the end of 2020. 2020 and 2021 saw a huge jump in commodity prices due to disruptions caused by Covid-19. With starting prices now much higher than in the past, and inflation expected to normalise over the long-term, the expected long-term return for commodities has fallen, compared to our last update in December

Looking at the long term, there are still challenges to face. Climate transition will affect investments on fossil fuel plants, making energy inflation less predictable. Geopolitical tensions can affect Natural Gas, pressure on demand of green transition materials might cause shortages and finally more extreme weather conditions can affect grains and energy equilibrium prices.

All of these factors make the commodity basket a useful diversifier in multi-asset portfolios.

As always, we recommend a diversified portfolio to clients in order to off-set some of the high risk/high rewards allocations with more steady income sources. 2022 looks set to be a challenging year – with a range of geopolitical and macroeconomic challenges.

In that context, it’s helpful to keep focused on the long-term. We see the greatest opportunity in equities and the stock market for our long-term outlook, especially as a means to counter inflation. As the value of cash degenerates, we anticipate more people moving their savings into investment vehicles.

Richard Flax is chief investment officer at digital wealth manager Moneyfarm

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