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 10 a.m. in New York.
Global equities have rallied by more than 35 from lows made in April and US high-grade fixed income has seen last 12 months' returns reach 5 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, 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, with the SP 500 just behind at 68.
European and Japanese equities stand out, potentially returning about 8%.
Emerging markets, however, lag at just about 4%.
On the bond side, we think US treasuries with a 10-year maturity will return nearly 5 per year, German bunds nearly 4 and Japanese government bonds nearly 2.
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%.
And for emerging markets, it's actually negative at around minus 1%.
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 US.
But we also need to put these valuations in context.
Yes, the SP 500's cyclically adjusted price-to-earnings ratio is near the highest level since the dot-com 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 is 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 portfolio risk, has shifted.
It's now flatter and lower than in previous years.
So it means taking on more risk in a portfolio right now won't necessarily boost returns as much as before.
Now, let's turn our attention to the classic 60-40 portfolio.
The mix of 60% stocks and 40% bonds, that's been a staple strategy for generations.
After a tough 2022, the strategy has bounced back, delivering above-average returns for three years in a row.
Looking ahead though, we expect only around 6 annual returns for a 60-40 portfolio over the next decade, versus around 9 average return historically.
Importantly though, advances in AI could keep stocks and bonds moving more in sync than they used to be.
If that happens, investors might benefit from increasing their equity allocation beyond the traditional 60-40 split.
Either way, it's important to realize that the optimal mix of stocks and bonds is not static and should be revisited as market dynamics evolve.
In a world where risk assets feel expensive and the old rules don't quite fit, it's essential to understand how risk return and correlation work together.
This will help you navigate the next decade.
The 60-40 portfolio isn't dead. and optimal multi-asset allocation weights are evolving.
And so should you.
Thanks for listening.
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The preceding content is informational only and based on information available when created.
It is not an offer or solicitation nor is it tax or legal advice.
It does not consider your financial circumstances and objectives and may not be suitable for you.
