2022 was a very difficult year for public investors as interest rates soared globally and stock prices dropped. The simultaneous drop in fixed income and equities led to widespread losses for a majority of public investors, while even the most conservative portfolios suffered negative returns.
According to our estimates, the largest losses were experienced by so-called saving or intergeneration funds, which have a return-maximisation investment objective. They lost on average 15% for the year. Stabilisation funds – with a more conservative asset allocation and higher exposure to fixed-income assets – lost around 10% on average. Reserve managers with a diversified portfolio of investment-grade fixed-income assets lost around 9%, not much less than portfolios diversified into 15% equities. Even the most liquid portfolios of these institutions – cash and short-duration bonds – did not escape slightly negative returns.
Last year was unique not just because all types of public investors experienced negative returns. It also represented the end of a prolonged period during which the returns of public investors – particularly long-term investors such as saving funds – were historically high. This was the result of very loose monetary and fiscal policies in most advanced economies, which led to high returns on equities and alternative asset classes and to a prolonged period of low volatility in global markets – the so-called ‘great moderation’.
The great moderation ended in 2022 when inflation rates soared and central banks were forced to start raising interest rates to bring inflation expectations under control. 2022 was also characterised by rising geopolitical tensions as Russia invaded Ukraine, leading to higher energy prices as well as sanctions, and the relationship between China and the US was put under further strain.
2023 has started on a more positive note largely as a result of growing evidence that we may have passed the peak in inflation, better than expected growth across advanced economies (particularly Europe) and the faster-than-expected lifting of Covid-19-related restrictions in China. However, uncertainty remains over whether inflation will continue falling rapidly, which could allow central banks to slow down or even reverse the interest rate hiking cycle later in the year, and whether the US will escape a deep recession as the impact of higher rates passes through the real economy.
Figure 1. Growth and inflation outcomes still very divergent
Economic scenarios clustered along 5-year economic growth outlook (LHS) and 5-year inflation expectations (RHS)
Source: UBS Asset Management
As public investors navigate this uncertainty, the best approach to asset allocation is to look at macro scenarios instead of just relying on a benign baseline scenario. In our framework, while a ‘softish landing’ scenario (no or only mild recession) has the highest single probability, the combined probability of the recession and stagflation scenarios is still very high. The resilience in the US labour market and the better-than-expected ability of the European economy to deal with the fallout from the Ukraine conflict slightly increased the likelihood of our softish landing scenario. However, most recent data point to a continuing deterioration in the US economy and a deeper recession is still possible.
As of February 2023, global markets are priced for a softish landing scenario but polarisation among investors remains high. Over the next two years, public investors should build portfolios that are resilient across a wide range of economic outcomes. The softish landing scenario would be very beneficial for global equities (8.9% annual return according to our fourth quarter 2022 capital market expectations), but the outcome for equities during a recession or stagflation would be negative (around -15% annually in both scenarios). For 10-year US bonds, our two-year expectation for the softish landing scenario is 5.5% per year and a still acceptable 2.3% in the case of stagflation. However, in case of a recession, we estimate an annual return of 18.1% for US 10-year bonds for the next two years.
Figure 2. Massive difference in long-term bond performance
Asset class performance comparison over two years
Source: UBS Asset Management
The current challenge for asset allocators is large divergence in portfolio outcomes across different scenarios. Should a deflationary recession scenario materialise, markets would go back to a lower-for-longer regime similar to that of the last few decades. If we instead enter a higher-for-longer inflationary regime, even risk-adverse fixed-income managers like reserve managers would experience equity-like volatility.
Still, what emerges from our two-year scenario analysis is that considerably higher yields now provide a cushion that creates an asymmetric risk between the more extreme scenarios of recession versus stagflation. Government bonds and other investment-grade fixed-income assets therefore have an important role to play in the portfolios of public investors.
Should the softish landing scenario materialise, expected returns in fixed income are expected to be higher than the returns experienced during the years of low interest rates and quantitative easing. This would benefit reserve managers that allocate the bulk of their reserves into government bonds and investment grade credits. Expected returns in cash and short-duration bonds would also be higher than in the years of the low-yield era. But for long-term investors, such as saving funds that have a higher allocation to equities and other riskier assets, government bonds could then become an important diversifier again.
If the recession scenario materialises, this asset class would generate very good returns and provide a cushion for losses on the equity portfolios, thanks to a stock-bond correlation that would once again be negative
The stagflation scenario is the most negative outcome for all public investors as it would represent a continuation of the trends experienced in 2022. In this scenario, inflation would remain high for a prolonged period, forcing the Federal Reserve to increase rates even more and, more importantly, keeping them very high for a long time. In this 1970s-style scenario, both (long-term) fixed income and equities would generate negative nominal and even lower real returns over the next two years, leaving little room for diversification for public investors. In such a scenario, cash and short-duration bonds would provide some protection but only in nominal terms.
Massimiliano Castelli is Head of Strategy and Advice, and Philipp Salman is Strategy and Advice, Sovereign Institutions, UBS Asset Management.
The views expressed are as of February 2023 and are those of the author and not necessarily the views of UBS Asset Management. This article is a marketing communication and the information herein should not be considered investment advice or a recommendation to purchase or sell securities or any particular strategy or fund. Information and opinions have been provided in good faith and are subject to change without notice.