Rebalancing Portfolios as Risk Premiums Drop

Our Chief Cross-Asset Strategist Serena Tang discusses how current market conditions are challenging traditional investment strategies and what that means for asset allocation.

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Welcome to Thoughts on the Market. I’m Serena Tang, Morgan Stanley’s Chief Cross-Asset Strategist.

Today – does the 60/40 portfolio still make sense, and what can investors expect from long-term market returns?

It’s Monday, December 22nd at 10am in New York.

Global equities have rallied by more than 35 percent from lows made in April. And U.S. high grade fixed income has seen the last 12 months’ returns reach 5 percent, above the averages over the last 10 years. This raises important questions about future returns and how investors might want to adapt their portfolios.

Now, our work shows that long-run expected returns for equities are lower than in previous decades, while fixed income – think government bonds and corporate bonds – still offers relatively elevated returns, thanks to higher yields.

Let’s put some numbers to it. Over the next decade, we project global equities to deliver an annualized return of nearly 7 percent, with the S&P 500 just behind at 6.8 percent. European and Japanese equities stand out, potentially returning about 8 percent. Emerging markets, however, lag at just about 4 percent. On the bond side, we think U.S. Treasuries with a 10-year maturity will return nearly 5 percent per year, German Bunds nearly 4 [percent], and Japanese government bonds nearly 2 [percent]. They may sound low, but it’s all above their long-run averages.

But here’s where it gets interesting. The extra return you get for taking on risk – what we call the risk premium – has compressed across the board. In the U.S., the equity risk premium is just 2 percent. And for emerging markets, it’s actually negative at around -1 percent. In very plain terms, investors aren’t being paid as much for taking on risk as they used to be.

Now, why is this the case? It’s because valuations are rich, especially in the U.S. But we also need to put these valuations in context. Yes, the S&P 500’s cyclically adjusted price-to-earnings ratio is near the highest level since the dotcom bubble. But the quality of the S&P 500 has improved dramatically over the past few decades. Companies are more profitable, and free cash flow -- money left after expenses -- is almost three times higher than it was in 2000. So, while valuations are rich, there’s some justification for it.

The lower risk premiums for stocks and credits, regardless of whether we think they are justified or not, has very interesting read across for investors’ multi-asset portfolios. The efficient frontier – meaning the best possible return for any given level of port