Alain Kerneis, Head of Strategy and Market Views within BlackRock Client Solutions, discusses what structural changes in the economy mean for future bond yields and the return potential from risky assets.
In the Q3 issue, we examine why the weaker global economic growth outlook may be rooted in structural trends that were exacerbated by the 2007-08 financial crisis. An ageing society, weak productivity growth and high public-debt levels we believe will keep interest rates low in major developed markets for a long time to come. In our view, investors will need to rethink asset allocation in response to this paradigm shift.
We expect the 10-year bond yields in some major developed markets to increase by just around 50bps on average for the next five years. Contained bond yields should be good news for the valuation of risky assets. We expect public equities and private markets to outperform high-quality fixed income for the next five years.
In our view, structurally low yields mean that pension funds should not delay the implementation of hedging programmes and consider hedging a large proportion of their liability risk. We believe that it will also be important to improve risk-adjusted performance via private markets, emerging market debt and other higher-yielding fixed income. For investors looking for additional returns through active management, we find that risk diversification can be achieved by diversifying across asset managers. However the marginal benefit drops off materially after adding more than one active manager in each actively managed asset class.
The majority of liability-driven investment (LDI) portfolios hold a mixture of both swaps and high quality government bonds to hedge interest rate and inflation risk. In the UK, we expect strong demand for gilts to limit the possibility for gilt-swap spreads to widen structurally. This contrasts with the historically wide US swap spreads. We believe that UK investors can exploit this discrepancy to their advantage without taking currency risk. In doing so they may be able to hedge liabilities at a potentially lower cost whilst also improving portfolio diversification.
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