Long Term Expected Returns Have Just Gone Lower – Morgan Stanley

Getting a decent return from a diversified portfolio is getting more difficult by the year. According to Morgan Stanley’s calculations, « a traditional 60/40 equity/bond USD portfolio will see 4.2% per annum over the next decade, while the same in EUR fares only slightly better at 4.7%, and GBP at 4.9%; only the JPY 60/40 portfolio sees above-average expected returns, driven by elevated equity risk premiums. »

The following chart illustrates the point in real terms for various asset classes.

Source: Morgan Stanley

The underlying truth is investors should lower their expectations. That doesn’t mean that there are no opportunities in financial markets. It’s just that the spectrum to derive a decent return with affordable risk is narrower than before.

The efficient frontier of a five asset-portfolio has just flattened and has been translating towards lower points, meaning the level of return has been declining over the last 30 years for the same level of risk.

Source: Morgan Stanley

What’s cheap ?

According the X-asset strategist team at the bank, it’s important to focus on « what’s cheap AND diversifies », what « can likely benefit from reallocation flows » and what’s « most insulated from cycle ebb and flows ».

That’s a lot of conditions to meet but in a nutshell, equities are still an asset class worth considering (despite being expensive to fairly valued), but mainly because the asset class might « benefit from long-run portfolio reallocation flows ».

Credit on the other side much draw caution from investors, because it’s expensive (versus its own history and other asset classes) and it might suffer from reallocation flows in a late cycle environment.

Govies are more a neutral, even though they are richly valued, simply because they provide diversification benefits to a portfolio (something we already read before).

The report contains some interesting charts that provide some perspective on asset classes.

Source: Morgan Stanley

The above 2 give us some historical perspective on equity risk premium in various equity markets and the historical performance of 60/40 portfolio in USD and EUR since 1970.

It’s interesting to see that despite the importance of US financial assets from a global perspective, a EUR 60/40 portfolio has provided more opportunities in the past to produce decent forward looking returns, simply because Europe has been through more periods of macro and political uncertainty than the US (remember that since 2008, Europe has been through 2 recessions against only 1 in the US).

Perhaps the most important message in the report is not how to build a diversified portfolio but how to protect capital.

This is the real challenge and, as we know it, the only and most efficient way to protect capital is to have significant chunk of a portfolio invested in cash.

Cash brings two benefits: 1/ serve as a cushion in the portfolio that helps weather market drawdowns and 2/ provide dry powder to seize investment opportunities when the market panics.

Of course, cash has a high opportunity cost when interest rates are zero or negative, but if you want to build wealth over the long run, you need to consider it.

About cash, you can read the following post and follow up with GMO’s paper (linked in the article).