We have fielded many questions about the role of real assets in portfolios and have often heard narratives about a preference for broad equities and private assets, driven in part by recent experience. We believe such thinking could have a material adverse impact on portfolio returns in the years ahead.
Research shows that asset allocation is a dominant driver of returns. As such, investors need to carefully evaluate the market and macro landscape to consider how the future could play out. In short, don’t let FOMO lead to poor portfolio construction.
What is driving this thinking? To begin, consider the past decade. In the 10 years to 2023, global equities delivered a total return in excess of 8% per year; US equities were even more impressive, with a stunning annualised return of more than 12%.
The performance of private assets was likewise remarkable, with double-digit returns in most categories amid extremely low (reported) volatility.
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Meanwhile, real asset returns were substantially lower. Excluding dividends, listed real estate returns would have barely been positive, while commodities had negative returns for the decade. Notably, US Treasury returns were also paltry, driven by the starting point of interest rates post the global financial crisis (GFC) and the sharp rise in rates in 2022.
These recent returns stand in stark contrast to the 10 years that ended in 2010, which extend into the recovery following GFC lows. During that decade, equities were, by far, the worst-performing asset class (barely positive even with dividends).
US Treasuries returns, meanwhile, were strong, driven by falling interest rates and accommodative monetary policy. Private markets were also substantially weaker — and registered higher volatility during that period. Conversely, real assets were standout performers, led by natural resources.
In short, assets that performed well from 2001 to 2010 fared worse in the last decade, and vice versa. It should come as no surprise that returns are often unstable and mean-reverting, with starting valuations being key to future performance.
While it is easy to become enamoured with what has worked best recently, it is common to see reversals of fortune. Chasing leaders and succumbing to FOMO after 2010 would have been a recipe for poor returns. The current backdrop suggests that another inflection point may be upon us.
Little juice left to squeeze from equities
One key headwind for equities over the next decade is the starting point for valuations. Consider the Shiller cyclically adjusted price-to-earnings (CAPE) ratio. This measure of valuation is near an all-time high. While extreme valuations neither guarantee disastrous outcomes nor serve as catalysts for corrections, history suggests that 10-year forward returns tend to be challenged when the starting point for valuations is this elevated.
Looking ahead, we believe US equity returns are likely to come (at best) solely from earnings growth and dividends rather than multiple expansion. More challenging outcomes are, of course, possible if multiples compress, as has been seen in previous episodes that began at these levels of valuation.
Private asset classes also face headwinds
There are also reasons to believe private markets will struggle to repeat the extraordinary returns and (likely mischaracterised) low volatility of the past decade. One factor that has impacted both returns and volatility across private markets — the multi-decade decline in interest rates — is likely behind us.
We believe yields of 4.0% to 4.5%, levels well above those that prevailed for most of the last decade, represent fair value in US Treasuries. Consequently, the opportunity for private assets to lever investments at ultra-low and stable interest rates has largely vanished.
Diversification challenges: Concentration and correlation
Diversification is another key aspect to portfolio construction and strategic asset allocation. In addition to the return challenges investors may face in equities, courtesy of elevated valuations, another issue of concern that may not be on investors’ radar is the high degree of concentration in market- capitalisation-weighted stock indexes.
Equity market concentration has more than doubled in the past decade. Strikingly, markets haven’t seen this degree of concentration since the so-called “Nifty Fifty” era, which ultimately endured a spectacular collapse during the stagflationary bear market of the early 1970s.
Just a handful of stocks now represent a large share of the market’s overall capitalisation and, therefore, risk and return outcomes. In effect, this results in a significant loss of diversification potential from equities.
Meanwhile, stock and bond returns have become increasingly correlated, meaning stock-bond portfolios offer less diversification than investors have come to expect. When inflation was low and falling, the correlation turned negative. Bonds served as a cushion, protecting portfolios when equities struggled.
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However as inflation moved higher and interest rates normalised the correlation between stocks and bonds turned positive. In 2022, this danger was there for all to see as both stocks and bonds declined, resulting in one of the worst years ever for the typical 60/40 portfolio.
Higher interest rates suggest better return prospects in fixed income markets and, therefore, a greater appeal than in the prior decade. However, increasing one’s allocation to fixed income comes with an array of added risks. For one, portfolios become more sensitive to inflation and duration risk.
Following Republican presidential and congressional wins in the US election, we see the potential for economic impacts in several areas, including trade policy, immigration and fiscal policy. All three can arguably be expected to deliver an inflationary impulse, stemming from higher tariffs, lower immigration, and lower taxes.
Furthermore, if today’s higher correlation between stocks and bonds persists, total portfolio volatility and risk may remain elevated owing to lower overall portfolio diversification.
Asset allocators are facing a historical inflection point
Our analysis indicates we are entering a period consistent with an inflection point in the economic cycle and market backdrop. We believe the coming decade will be characterised by slower economic growth and higher, more volatile inflation (averaging around 3%, compared with the 1.8% rate of the previous decade).
In short, we see a reversal of fortunes in the performance of the major asset classes over the next decade compared with the past 10 years.
Given their stretched valuations, we believe US equities are set for more subdued annualised returns of about 7%, well below their returns in the last 10 years. Non-US equities may produce similar returns, as a more attractive valuation starting point is offset by lower levels of profitability and slower earnings growth.
Higher rates have made fixed income assets increasingly attractive. Though US Treasuries should see an improvement over the previous decade, our expected annual return of approximately 4% over the next 10 years is nevertheless relatively modest, and inflation surprises could threaten real returns.
In contrast, all core real assets categories are either neutrally or attractively valued and, we believe, positioned for meaningfully more substantial returns— compared with both the prior 10 years and relative to other asset classes.
We see companies poised for higher profitability levels, driven by factors such as commodity undersupply (following years of underinvestment) and a move away from globalisation toward onshoring. Other persistent inflationary pressures, as well as greater geopolitical uncertainty, also support real assets.
Natural resource equities and real estate are best positioned for the new regime, with expected annual returns around 8% — nearly double their prior-decade performance. Expected total returns for global listed infrastructure also appear attractive around 7-8%. Commodities, we believe, will see the most substantial improvement in returns amid undersupply and higher production costs.
Vince Childers (pictured left) is head of real assets multi-strategy at Cohen & Steers and Jeffrey Palma is head of multi-asset solutions
