Looking backward, looking forward

The end of a year, the end of a decade – a time to reflect and to plan for the future.

Depending how you’ve been invested over the past 10 years, you might be feeling some satisfaction with your portfolio performance. The 2010s have delivered extraordinary returns across financial assets. Global bonds have returned 49%, Asian stocks 74%, European stocks 102%, and the US market 245% since the end of 2009. For developed market equities this has been the best decade since the 1980s. Correctly picking the growth stocks from the US market would have generated even greater returns. The Nasdaq has returned 325%, with Apple, Microsoft, Alphabet, and Amazon creating USD 3.5 trillion in value.

How will investors boost their portfolio performance in the next decade, while minimizing the chance of regret? In this letter I look at three key strategies:

1. First, remain invested in equities.

• Although returns are likely to be lower in the 2020s than the 2010s, we believe stocks are still likely to outperform other publically listed asset classes. It might seem hard for investors holding cash to buy in now after such a sustained rally, but investing is about looking forward, not back. Systematic put selling or capital protection strategies are both approaches that can help investors manage their fears around near-term equity volatility.

2. Second, allocate toward longer-term growth trends within equities.

• Large-cap technology stocks probably won’t repeat their performance of the last decade, but other parts of the market do have the potential to deliver above-average growth. We look to stocks focused on sustainable investing, digital transformation, genetic therapies, and alleviating water scarcity.

3. Finally, look for alternative risk premiums.

• With the available returns from public markets likely to be relatively muted, investors should think carefully about whether they could boost their returns by taking advantage of illiquidity premiums in private markets. If you are not likely to need to access a portion of your funds in the medium term, you could shift assets you would otherwise allocate to liquid public equities into private markets, and earn additional potential return. Over the course of a decade an estimated 1–3 percentage point illiquidity premium per year translates into an additional 10%–35% gain.

Nearer term, we are making no changes to our tactical asset allocation this month, retaining a neutral overall tactical stance on equities. Recent news headlines have suggested that the US and China are edging towards postponing the scheduled 15 December US tariff increase while they continue to negotiate. This is our expectation, and our neutral positioning reflects this outcome. Clearly there is two-way risk to this scenario, with a rollback of tariffs likely to prompt a rally in equities and an imposition of the December levies likely to be followed by a sell-off. We continue to seek relative value tactical trades within equities, favoring Japan relative to the Eurozone.

We prefer to take more risk by finding alternative sources of yield, notably in emerging market sovereign bonds, and in our FX strategy overweighting the Indian rupee and Indonesian rupiah relative to the Australian and Taiwan dollars.

Staying invested

For portfolios fully invested in equities, it has been a great year for returns, but we acknowledge there are some short-term reasons not to be overweight equities. Even Larry Kudlow, US President Donald Trump’s economic advisor and an eternal optimist, has recently admitted that the president may not hesitate to add more tariffs on 15 December. The threatened reinstatement of US tariffs on steel and aluminium exports from Brazil and Argentina, as well as on a range of French exports, also shows that trade risks are not confined to China.

Meanwhile, earnings expectations could be set for disappointment: next year we expect growth of just 4% compared with consensus forecasts for 10%, and the scope for fiscal stimulus to change the growth outlook outside of Asia looks limited, although the Fed does appear to be more willing to let the US labor market “run hot.”

Against this backdrop, we are tactically neutral overall on stocks and prefer relative value trades within equities, favoring consumer-facing sectors over those reliant on business investment spending.

But strategically, in public markets, there remains no alternative to equities. Even if global GDP growth were to stay at the decade-low annual rate we forecast for 2020, the world economy would still expand 80% in nominal terms by 2029 at the current global inflation rate of 3%, offering meaningful scope for long-term growth in corporate earnings. Absolute valuations for global equities, based on a 12-month forward price-to-earnings are 16.1x, close to their long-term average since 1987 of 15.7x. And the contrast to bonds is stark. Equity dividend yields are close to a record high relative to bond and cash yields in Europe. And in the US the equity risk premium is 5.7%. We expect developed market equities to return 4%–6% a year in local currency terms over the coming seven years, and 9% a year for emerging markets.

The challenge for many investors is how to balance this longer-term logic with near-term fears. Structured strategies can provide one way of doing this.

Investors who are holding cash, but are afraid to deploy capital with stocks close to an all-time high (see breakout below), can think about defensive equity entry strategies as one option to earn return while waiting to buy into stocks in a disciplined way. Over the long term we would expect such strategies to underperform stocks, but by allowing investors to combat their behavioral biases and get themselves invested in growth assets, such strategies have the potential to improve the long-term return profiles of portfolios.

Equally, investors already invested in stocks and keen to realize gains could consider hedging some equity exposure (either by buying a put option or by substituting a portion of their equity allocation for a capital protected note) to lock in some gains. Hedging doesn’t come for free of course, but when cash rates are close to zero, investors have a higher chance of realizing long-term gains if hedges help them stay more fully invested through periods of volatility.

See more in How should investors deal with lump sums?.

Seeking high growth sectors

If the 1990s were about the internet (Nasdaq +812%), the 2000s about commodities (oil +333%, gold +206%), and 2010s about Big Tech (S&P Tech index +378%), what will be the dominant trend of the 2020s?

We favor four areas with potential:

1. Sustainable investing

Consumers, governments, and regulators are all going to be big drivers of a shift toward sustainable investments and products over the next decade, and we think that investors who get ahead of that trend will be rewarded. Take recent comments in Europe as an example. European Central Bank President Christine Lagarde has said she wants climate change to become a “mission critical” priority for the European Central Bank (ECB). And Italy’s Prime Minister Giuseppe Conte recently suggested that the government should “strip out green projects funded with green bonds [from its] deficit calculation.” If this trend leads to a green-focused fiscal and monetary stimulus package in Europe, the sustainable investing market is likely to be well supported.

2. Genetic therapies

Fans of Netflix’s documentary series Unnatural Selection will know that genetic therapies represent a paradigm shift in medicine, with the potential to revolutionize healthcare delivery and disrupt the biopharma industry. Research scientists from MIT and Harvard recently announced they have developed a gene-editing technique that could help correct nearly 90% of genetic diseases, and we are now seeing a whole new generation of gene and cell therapies gaining regulatory approval to treat certain rare diseases and cancers. Large-cap pharma is sitting up and taking note, and we therefore expect to see heightened deal activity in the next decade. Just this month, Japan’s Astellas Pharma announced the acquisition of Audentes Therapeutics at a106% premium to its closing price, and we estimate that large-cap pharma and biotech companies have now spent USD 41 billion acquiring gene and cell therapy companies since 2017. Of course, we recommend investing in this trend through a well-diversified portfolio of companies to manage the risks associated with clinical failure.

3. Digital transformation

The combination of 5G, artificial intelligence (AI), big data, and cloud computing will define a new era of digital transformation and innovation in the decade ahead. South Korea, the US, and the UK have already begun rolling out 5G networks this year, and last month China’s three state-owned mobile operators launched 5G services in 50 cities. Global 5G wireless network infrastructure revenue will reach USD 4.2bn in 2020, an 89% increase from 2019, according to research group Gartner. These rollouts will support further growth in the Internet of Things (IoT). By the end of this year the enterprise and automotive IoT market will have reached 4.8bn endpoints, a 21.5% increase over 2018, with a similar growth rate predicted for next year, according to Gartner data.

To benefit from digital transformation, we advise diversified investing focused on six key themes:

• Digital data
• Enabling technologies
• E-commerce
• Fintech
• Healthtech
• Security and safety

4. Water

The world faces a mismatch between water demand and supply, which will be exacerbated in the decade ahead by the effects of demographics and climate change. China and India represent 35% of the world’s population, yet have access to less than 10% of its freshwater resources. Owing to the urgency and scale of water-related issues, and the need for capital spending in emerging markets, we expect continuous revenue and profit growth for the entire water value chain. We’re already seeing this trend playing out. In November, China’s premier Li Keqiang said that China needs to increase investment in water infrastructure to combat water shortages created by pollution and rising populations in its arid northern regions. Meanwhile, in Europe this month, the European Commission agreed on new minimum requirements for the safe reuse of treated urban wastewater in agricultural irrigation, a practice which is established in only a few member states, and will require further investment to implement.

Boosting returns with a better understanding of liquidity needs

As well as staying invested and seeking higher return parts of the market, in the next decade investors will also need to look at other sources of risk premiums, such as those available in private markets. Academic studies estimate that private markets offer an illiquidity premium of 1–3 percentage points. If this holds true over the next decade in a world of lower returns for financial assets in general, this would represent a greater proportion of overall returns than in the past. In private markets we anticipate returns of 8%–10%, due to the effect of illiquidity premiums, access to niche opportunities, and manager emphasis on driving operational value.

With the case for private markets more compelling, what sort of allocation should investors make to this asset class? Much depends on an investor’s personal ability to tolerate medium-term illiquidity. One approach that can help clarify this is our Liquidity. Longevity. Legacy.* framework. In this framework, the Liquidity strategy is designed to cover near-term spending needs, the Longevity strategy to meet your needs for the rest of your lifetime, and the Legacy strategy for assets in excess of those needed for spending.

Investors can consider allocating a substantial portion of their Legacy strategy to private markets, and, depending on the time horizon of their Longevity strategy, could also consider allocating a portion of this strategy toward private markets to improve returns and enable their portfolio to keep pace with inflation.

We generally recommend a phased approach to buying into private markets to ensure investors build exposure across the business cycle. At the current stage in the cycle we favor a more defensive approach, looking for strategies less dependent on the macro environment. We like managers with proven operational value creation capabilities and investments that reflect durable organic growth rates. In private debt markets, we prefer more conservative managers who can deploy capital in less explored areas to maintain attractive risk-rewards for investors.

*Liquidity. Longevity. Legacy. disclaimer: Timeframes may vary. Strategies are subject to individual client goals, objectives, and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.

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