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What a difference a crisis makes

Once a year before December draws to a close, our Group Chief Investment Officer, Yves Bonzon, publishes 10-year expected returns for asset classes and sub-asset classes. In normal times these remain valid for a year. Download the Investment Guide to see how our assessment changed.

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A look at the bond market
After the US Federal Reserve adopted its zero-interest rate policy to fight the economic effects of Covid-19, the yield on government debt fell significantly and we now expect US government bonds to yield 1% less going forward. Turning to Europe, reductions in government bond yields in EUR, CHF and GBP have been less extreme so far, as they were mostly already close to or below zero. Corporate, high-yield and emerging-market bonds offer much higher yields as their spreads over government bonds have ballooned in the crisis, adding to expected returns. Yet, in light of a looming recession, we assume that bond defaults will increase, so that any theoretical rise in yields will be offset.

Increased risk premium for risky assets
We had fairly low expectations for future returns across all asset classes at the end of 2019, but the crash in the price of risky assets has improved their risk premia. We estimate that the crisis will reduce corporate earnings by 20%–30%, but we foresee a catch-up over 10 years and forecast a return to average corporate earnings and valuations within this period. This has led us to add 2% to our expected annual risk premium, and we now expect world equities to return 1% more each year over 10 years from current levels than we had anticipated at the end of 2019; while US government bonds are likely to earn 1% less. Similarly, we have raised our expectations for other risky assets, including hedge funds and private equity.

A fresh perspective on asset classes
At first glance, the change in expected returns might seem small, but compounded over 10 years the consequences are massive – particularly in the current low-yield environment. Indeed, the new return expectations lift the total return from equities by almost a quarter and shrink those from bonds by a half. This can wrong-foot investors, if they let markets decide on their asset allocation. Even though the Covid-19 crisis has been one of the biggest events in all of our lifetimes, it will not dominate headlines forever. As times slowly return to normal, we assume that equities and other risky assets will outperform bonds by a wider margin than we thought at the end of last year. In conclusion, the efficient frontier is now steeper, particularly in US dollars, making the relative attractiveness of risky assets over risk-free assets greater. In other words, the expected payout per unit of risk should be higher going forward. What a difference a crisis makes.

The efficient frontier

  • Evidently, it is not possible for investors to say they would like to achieve a high return while taking only a small amount of risk. Investors should therefore look to build a portfolio which achieves either the maximum return possible for a given level of risk, or which ensures the minimum level of risk for a given target return. A portfolio which does this is known as an optimal or efficient portfolio.
  • The concept of constructing an optimal portfolio is a cornerstone of modern portfolio theory and was introduced by the Nobel Laureate Harry Markowitz in 1952. All optimal portfolios build the so called ‘efficient frontier’. In essence, an investor should aim to construct a portfolio of different asset classes which lies on this efficient frontier.

Download the Investment Guide

The crisis has revealed some of the conceptual shortcomings in politics and economics and shown our vulnerability to such shocks. For investors, it is important to learn from what we have seen and prepare for the future.

To download the Investment Guide, please enter your e-mail address below and you will receive a download link via e-mail.