Monday, January 24, 2022

Limited upside for stock and bonds over the next 5 years


Equity markets are still overvalued, and yields are still at low levels. This combination does not look good for estimates of asset class return for the next five years. The simple approach of 60/40 stock/bond allocations will disappoint relative to the last five years.

From the AQR return estimates, which are similar to what is calculated from other firms, the expected real return for US equities is below 4% and real yields between credit and government bonds is at best zero. Surprise inflation or a recession will only make these estimates worse. 


These poor return forecasts have been made for the last few years and they have proved wrong. The better performance than expected is associated with exogenous factors like strong fiscal stimulus and loose monetary policy which provided an offset to what should be considered normal conditions. 

It cannot be assumed that governments can or will prop-up financial markets, so investors must look at other asset allocations to provide extra return. International diversification will help, but the only real alternative is to play style factor diversification. Even this diversification play will only 1-2% real return but that will add close to 50% extra return in the current unfavorable environment. 

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