Morgan Stanley’s updated Capital Market Assumptions

2020 was a year no one saw coming—a period dominated by crisis and response. In Australia, the early part of the year was heavily influenced by the bushfire catastrophe, which was quickly overshadowed by the evolution of COVID-19 and the rapid policy response. In line with international markets, the ASX200 fell approximately 36% peak to trough.

This fall, however, was followed by an unexpectedly rapid rebound, which means we’re ending the year in an interesting place. Morgan Stanley Wealth Management Australia Research (Morgan Stanley Research) believes the cycle has been reset and we are now in the recovery phase, as the world exits the deepest fall in economic activity since World War II. Even if challenges remain, things are looking positive for the years ahead and we should see the economic growth recover and overall uncertainty decline. At this point in the cycle, it may be a good time for investors to make sure the positioning for their portfolios is appropriate.

Morgan Stanley Research recently updated its capital market assumptions (CMAs), which are forecasts that estimate the returns and volatility of global asset classes over the strategic seven-year horizon. These serve as key inputs into its strategic asset allocations recommendations used in its various risk profiles and model portfolios.

These new strategic forecasts reflect the ongoing significant market movements that have occurred since the last CMAs update in 2016. The most notable change is the steep decline in interest rates, which is supporting high valuations across risk assets. Morgan Stanley Research’s return expectations are lower across most asset classes than the last CMAs update because the large policy response to the COVID-19 crisis has prevented the traditional valuation reset in risk assets. This has important implications for investors of all types and in all risk categories.

To derive the CMAs, the Research team conducted an assessment of the macro environment for the next seven years. Here are the key takeouts from the strategic forecasts:

• Cash and government bonds are likely to return only 0% to 1% over the cycle, given the low starting point and the expectation of cash rates being on hold in Australia and the US for the next 2-3 years, before rising in the second part of the cycle.

• Equities are facing a major headwind as valuations normalise but will be boosted by an improved earnings outlook. A key consequence from relatively depressed bond yields is that it has kept valuations elevated in equity markets, which is likely to impact future returns. However, on a positive note, we are at the beginning of a new economic cycle, meaning we should see stronger earnings growth from here. Australian equities offer appealing prospects with the combination of strong domestic fiscal stimulus and loose monetary policy.

• The AUD is expected to gain through the cycle. With Australian and Chinese growth poised to be strong, while the economic recovery and widening deficits will likely weigh on the USD in the cycle ahead, we expect the AUD to average US$0.80 through the next economic cycle.

• Corporate credit is attractive on a risk-adjusted basis – corporate credit’s mild correlation to equities, central bank buying and continued search for yield is likely to fuel demand for corporate credit – especially higher-risk securities which carry lower duration.

• Alternative assets will play an increasing role. Alternative defensive strategies provide an appealing substitute for fixed income and cash with less duration and credit risk. Similarly, alternative growth strategies offer a risk/return profile superior to equities. While they do not appear likely to exceed equity returns through the cycle, their lower volatility results in a higher returns for the portfolio relative to the risk taken. The outlook in private markets is more appealing for credit and equity than property.

The latest strategic view is that we are expecting growth, and more importantly, inflation to revert back to trend – both overseas as well as domestically. This is expected to be sparked by a faster economic recovery, changes to some of the structural disinflationary forces over recent decades, a sizeable and coordinated policy response during the COVID-19 crisis, as well as more explicit commitment from central banks to reach their inflation goals. 

It is worth noting that given the high uncertainty around its central case, Morgan Stanley Research have used relatively conservative earnings growth numbers with regards to the starting point for its forecasts, particularly in relation to the market cycle. This means there is potential upside risk on the earnings side, which in turn could translate into higher equity returns.

At this point, in light of the macro and market assumptions, Morgan Stanley Research has also identified scenarios that could pose risks to the CMAs. In particular, they’re watching for any signs that inflation could overshoot expectations, thus prompting central banks to tighten policy much sooner than expected, and potentially leading to higher bond yields and lower equity valuations. 

 

Over the next several months we will be publishing a series of articles looking at key themes from the CMAs in greater detail – Australian versus international equities, the future for fixed income, the return of inflation, and the appreciation in the Australian dollar. Speak to your Morgan Stanley financial adviser for more detail on Morgan Stanley Wealth Management’s portfolio construction recommendations and for a copy of the full report. Plus, more Ideas from Morgan Stanley's thought leaders.