Long‑Term Return Expectations, Near‑Term Outlook, and the Inverted Yield Curve

Research Affiliates explain why their long-term return forecasts have risen across asset classes and the implications of their near-term outlook for U.S. recession.

Jim Masturzo, CIO for multi-asset strategies at Research Affiliates, discusses the shift higher in their capital market assumptions as well as their outlook for slowing U.S. growth. Campbell Harvey, partner and director of research at Research Affiliates, explains how a key indicator of coming recession is flashing red, and what this may mean for the banking sector. As always, their insights represent Research Affiliates’ views in the context of the PIMCO All Asset and All Asset All Authority funds. All Asset All Access is published quarterly.

Views expressed here are from Research Affiliates as of 6 July 2023.

Q: How has recent market volatility influenced Research Affiliates’ capital market assumptions, which serve as the core analysis informing portfolio decisions within the All Asset strategies?

Masturzo: Over the past year and a half, our long-term (10-year) asset class return expectations have shifted significantly. If we think back to the end of 2021, assets were facing three strong headwinds: a rising global interest rate environment, increasing global inflation, and expensive valuations across most major asset classes. At that time, our long-term capital market forecasts showed an average expected return of 3.3% across 15 different asset classes.1 Today, for the same mix of assets, our average expected return is almost double, at 6.4%. Furthermore, this increase isn’t tied to a few assets, as every one of the 15 asset classes has a higher return expectation today than at the end of 2021, according to our research.

This across-the-board increase in expectations translates into a projected rise in the efficient frontier (i.e., the hypothetical set of investments that capture the highest returns relative to risk). When realized asset returns are negative – as they were in 2022 for all major asset classes except commodities – expected returns normally tend to rise. This can be good news for investors who focused on positioning portfolios in light of improving future opportunities. Even better news: A strict parallel rise in the efficient frontier may also allow investors to maintain their return per unit of risk with lower-volatility assets. This is a potential benefit of tactical asset allocation over strictly targeting a level of volatility for one’s portfolio.

Taking this simple model of a parallel shift in the efficient frontier a step further, from December 2021 to June 2023 we’ve also seen a flattening of the yield curve, which means that the risk/return trade-off of lower-volatility assets appears more attractive than it did 18 months ago. Consider, for example, our expected increase in the Sharpe ratio (a measure of risk-adjusted return) for core bonds over that time frame (see Figure 1). Rising yields in bonds not only improved income potential but tended to improve bond valuations via reduced risk of future central bank rate increases. This flattening also led many investors to look to lower-risk assets over higher-risk assets, all else equal.

Research Affiliates' risk-adjusted return estimates for core bonds increased dramatically between December 2021 and June 2023