The historic rise in global bond yields over the past two years has reconfigured the investing landscape in a way not seen since before the global financial crisis. Rates near 5% across developed markets now give investors more choices in crafting their goal-aligned wealth plans than at any time in over a decade.
However, navigating this new rate environment also presents challenges. Multi-asset portfolios have struggled to generate meaningful returns since stocks took off in late 2020. For the first time, investment grade debt is at risk of delivering negative total returns for three consecutive years. Equity markets have also lacked direction amid wild swings in certain stocks and sectors.
As a result, our clients have significantly increased their cash holdings in money market funds, Treasury bills, and bank deposits. Cash yields after inflation are now among the highest in 20 years. At the same time, higher bond yields and reasonable equity valuations mean that forward-looking returns across many asset classes seem more promising than in over a decade.
It is clear the markets have entered an entirely new interest rate regime as a result of the rate reset. In this report, the Global Investment Strategy Group analyzes how investors can optimize their portfolios in light of the new dynamics across inflation, cash, bonds, stocks, credit, and other asset classes. Their view is that the rate reset represents a once-in-a-generation opportunity for investors to lock in higher yields that may not be available again for some time.
The report expects inflation will continue cooling in both the US and Europe, approaching central banks’ 2% targets by late 2024. Encouraging signs include moderating price increases in services sectors and signs shelter inflation will continue declining. However, inflation will likely settle between 2-2.5% going forward rather than returning to the very low levels of the 2010s.
Stocks and real assets can help hedge inflation risks. Large companies will maintain pricing power and margins even at higher inflation levels. Real estate income also tends to outpace inflation over the long-run. Commodities, infrastructure, and timber provide inflation hedges as well. Overall, an inflation range of 2-3% is generally favorable for stock returns.
Cash yields an attractive 5% after inflation currently. However, holding relatively more cash than usual is probably not the best use of one’s portfolio given expectations for falling rates and improving earnings in 2024. Cash works less well in such an environment.
Designing a portfolio with assets outside of cash can reduce the capital needed today to fund long-term goals with high confidence. Even a portfolio of just core bonds could require 15% less capital than holding all cash to maintain the same spending. Factoring in other assets like equities, high yield, and alternatives could further optimize a portfolio.
Higher starting yields mean bonds across the yield curve now offer attractive long-term return potential not seen in over a decade. Core bonds are projected to deliver 5%+ annual returns over the next 10-15 years per J.P. Morgan’s long-term capital market assumptions. Price appreciation may also come as rates fall in 2024.
Within fixed income, the report recommends focusing on tax-efficient strategies. In the US, this means municipal bonds with their extremely low default rates. Globally, local currency debt provides tax benefits. Maturity ranges of 3-10 years balance yield and downside protection.
Given bonds’ new competitive positioning versus stocks, investors should reconsider their allocations. Those seeking lower volatility could reasonably replace some equities with bonds while still achieving their goals. Others may add fixed income to portfolios. The rate reset has created a generational opportunity in bonds.
Equities still offer the potential for long-term capital appreciation needed in portfolios. Large-cap earnings growth is expected to accelerate in 2024 even as economic growth slows. Valuations also appear reasonable globally given projections for profit growth.
Trends like the proliferation of artificial intelligence and new drugs for weight loss management could be long-term stock market outperformers. Infrastructure, construction, and defense spending increases also position certain sectors for gains.
When considering stocks, the report recommends structuring equity holdings to hedge inflation, extract yield, or increase upside based on one’s goals and risk tolerance. Private markets also offer opportunities, such as secondary private equity funds amid a lack of distributions. Overall, stocks seem poised to deliver gains in 2024 and beyond.
Higher rates will bring more stress to interest-rate-sensitive areas of credit like commercial real estate, leveraged loans, and parts of consumer debt. However, the report expects these problems will remain contained and not trigger a recession.
Strong household and corporate cash flows plus moderating inflation should allow central banks to cut rates before credit stresses do serious damage. Opportunities may arise for investors in commercial real estate loan sales, partnering with borrowers on refinancings, and private credit funds capturing market share from weakened loan and high yield bond markets.
Relative value strategies and managers able to identify sector- or subsector-specific dislocations stand to benefit. Overall credit stresses seem manageable and could create well-priced investments for long-term oriented portfolios.
The rate reset has significantly altered the investment landscape, but also created a wide range of attractive options for investors. Personalizing one’s portfolio to optimize goals in light of the new dynamics across asset classes is key. Locking in higher yields now rather than waiting seems prudent given the once-in-a-generation opportunity presented.
Markets will evolve, as will risks, but harnessing reconfigured markets to help achieve long-term financial plans is the overarching aim. The Global Investment Strategy Group analysis provides a framework for investors to evaluate tradeoffs and capitalize on a shifting environment that could benefit forward-looking, strategic portfolios.