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Investing for a world in transition

November 24, 2023

Investors may need different kinds of diversification in a world of transition.

Contributors

Grace Peters

Global Head of Investment Strategy

Monica Issar

Global Head of Multi-Asset and Portfolio Solutions

John Bilton

Head of Global Multi-Asset Strategy, J.P. Morgan Asset Management

The changes are profound – if in some ways elusive. Today much of what defines the investing environment is in transition. But we may not appreciate the breadth and depth of the change.

Consider:

The economy is in transition as persistent disinflation transitions to two-way inflation risk.
Policy is in transition as ultra-easy monetary policy transitions to more conventional monetary policy and fiscal restraint shifts to fiscal activism.
Technology is in transition as the potential of artificial intelligence (AI) begins to emerge.
Climate is in transition from conventional energy to renewable energy.

For investors this is an empowering moment in many ways, and it may require action investing for a world in transition.

With the economy and asset markets in flux, portfolios themselves may also need to make a transition. This became especially clear in 2022, when investors learned that bonds hedged risky assets against growth shocks but did little to hedge against inflation shocks.

Today we believe that a 60/40 allocation (60% equities, 40% bonds) can once again form the bedrock of portfolios. But there is so much more to explore beyond the 60/40. Markets now appear to be offering a promising and diverse opportunity set.

Wealth plans, optimized allocations

Long Term Capital Market Assumptions (LTCMAs) are the work of more than 60 investment professionals from across J.P. Morgan Asset & Wealth Management. They scrutinize over 200 asset and strategy classes to provide return outlooks over a 10- to 15-year investment horizon. These annual outlooks help to drive our strategic asset allocation and power the tools we use to build portfolios tailored to an investor’s goals.

When someone sits down with a J.P. Morgan advisor to craft or review their wealth plan, J.P. Morgan Asset Management’s return assumptions help create a more informed and personalized investment framework – one that considers a person’s unique circumstances, risk tolerance, liquidity needs and desired financial outcomes. Updating a plan every year with our latest outlooks can also help optimize an investor’s asset allocation and provide a clearer path toward achieving their financial goals with confidence.

Examine ways to build, extend, enhance

The LTCMAs discusses extending cash, active enhancement:

Extend out of cash and delve deeper within core assets

Cash rates may be high today (and it’s always important to have the right amount of cash in a properly funded liquidity bucket). But historically, every major asset class has performed better than cash over the 10- to 15-year LTCMA investment horizon.

Active allocation and manager selection

Bear in mind that given the higher cost of capital expected over a 10- to 15-year investment horizon, manager selection can play an increasingly important role.

Slightly higher growth and inflation

Building long-term outlooks begins, as always, with a macroeconomic perspective.

This year’s LTCMAs consider the impact of multiple transitions, across the economy, policy, technology and energy. These transitions will likely have varying effects on global growth and inflation, at different times and in different regions and sectors.

We see a positive impact on growth from the technology transition. While the timing and magnitude is uncertain, we expect that AI will help increase productivity, which could boost GDP. Improved labor force growth in the U.S. and increased investment in the energy transition in Europe could also support growth.

On balance the LTCMA global growth assumption rises slightly, to 2.4%.

Higher inflation is expected. For example, in the U.S., euro area and UK, the LTCMAs anticipate a 2.4% rate over the next 10-15 years, well above the pace of the 2010s.

Stronger wage growth helps boost inflation assumptions from 1.8% to 2.2% in the euro area and from 0.9% to 1.4% in Japan (where any inflation at all had long seemed an improbable prospect). The LTCMA U.S. inflation assumption falls slightly, from 2.6% to 2.5%.

Potential for higher bonds outlook, lower equity estimate

High policy rates support the LTCMA fixed income assumptions: The USD cash assumption rises 50 basis points (bps), to 2.9%, and the Global Aggregate bond assumption jumps 40bps, to 5.1%.

Following the reset in yields, real bond returns could be robust across the fixed income complex. Critically, we believe investors can again rely on bonds both for income and diversification from disinflationary growth shocks.

In addition, in the LTCMAs the gap between developed market and emerging market equity return assumptions narrows this year.

U.S. large cap return assumptions decline from 7.9% to 7.0%, reflecting higher valuations. The LTCMAs see an attractive outlook for non-U.S. developed markets. Profit margins will be supported by various factors, the outlook suggests: in Europe, a sectoral shift to more profitable and higher return-on asset sectors; productivity enhancements, including the increasing adoption of AI; and pricing that does not revert fully to pre-pandemic levels.

By contrast, the LTCMA assumptions for emerging market equity have moderated. Investors are increasingly skeptical about the outlook for Chinese equities and unwilling to pay high multiples. However, because Chinese stocks did not participate in the 2023 rally, a lower starting point supports estimated returns.

Despite some well-flagged issues in some segments of U.S. commercial real estate and persistent weakness in China, we believe that the outlook for core real estate is strong. (For example, the U.S. core real estate assumptions rise from 5.7% to 7.5%).

Real Estate income has generally outpaced inflation over the past 30 years

This line chart shows real estate income and inflation from 1991 to 2023.

Source: J.P. Morgan Asset Management GRA Research, NCREIF, Bureau of Labor Statistics. Data as of June 30, 2023.

Currency: A new path to dollar decline

In our view, the U.S. dollar (USD) remains overvalued and looks set to decline against most other currencies over a 10- to 15-year investment horizon. However, over the longer term, we think that shifts in capital flows, rather than pure interest rate and economic growth differentials, will dictate the path of currencies.

Here we focus in particular on the eurozone and Japan. The two regions struggled through a long stretch of stark underperformance in nominal growth, interest rates and equity markets. That period looks to have ended. As capital flows shift back toward the euro area and Japan, their currencies will likely strengthen and compound the dollar decline.

The prospect of a new path to dollar decline may be of particular interest to our many clients whose portfolios are overweight USD and U.S. assets. Currency hedging strategies are designed to help mitigate foreign exchange risk and may offer the potential for both portfolio returns and diversification.

Meeting the diversification challenge

Clearly portfolio diversification will be a persistent challenge as the economic environment moves through a state of transition. (Hiding out in cash may be tempting, but remember that cash has historically underperformed over the long term.)

Owning both stocks and bonds is a first principle of portfolio diversification – but it’s just a start. That’s because bonds can help hedge portfolios of riskier assets (for example, stocks and high yield credit) against economic growth shocks, but can do a subpar job hedging them against inflation shocks. Investors learned this lesson the hard way in 2022, when stocks and bonds both posted year-end losses for the first time since 1974.

One year ago, the LTCMA message focused largely on the jump in estimated assumptions for the core set of public market assets. This year, it is more about the breadth of opportunity available across the wider asset markets. When inflation risk is two-way and stock-bond correlation is no longer reliably negative, investors may need to explore different kinds of diversification to hedge portfolios and boost potential returns. Remember diversification does not guarantee investment returns and does not eliminate the risk of loss. LTCMA’s are not a retail product. This article is for educational purposes and does not constitute investment advice.

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Key Risks

The price of equity securities may rise or fall due to the changes in the broad market or changes in a company's financial condition, sometimes rapidly or unpredictably. Equity securities are subject to "stock market risk" meaning that stock prices in general may decline over short or extended periods of time.

Bonds are subject to interest rate risk, credit, call, liquidity and default risk of the issuer. Bond prices generally fall when interest rates rise.

Diversification and asset allocation does not ensure a profit or protect against loss.

International investments may not be suitable for all investors. International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Some overseas markets may not be as politically and economically stable as the United States and other nations. Investments in international markets can be more volatile.

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