The forecast, which emphasizes the importance of sound risk management, projects the likely annualized returns and risks of various asset classes and investment strategies over the next seven years. Its major theme is that, in the wake of the deepest economic downturn in several generations, the array of possible future economic and financial market outcomes appears even wider than usual. As a result, it is more important than ever to construct diversified portfolios.
“Investors must allow for a wide range of outcomes with respect to how the economy recovers and the financial markets’ reaction,” said Mr. Macey. “For instance, one can envision a scenario in which we see virtually no inflation. You can just as easily envision a scenario with high rates of inflation. Given today’s uncertainties, we believe it’s smart to follow the advice of Nobel Prize-winning economist Harry Markowitz, who reminds us that a good portfolio is more than a list of stocks and bonds; it is a balanced whole that provides an investor with protections and opportunities in the face of a wide range of contingencies.”
One contingency seen by Wilmington Trust’s experts is a period of lower economic growth than what typically follows a deep recession. Deep recessions are usually followed by sharp recoveries, like a coiled spring releasing, according to Mr. Macey. “In this case, however, we have a deep recession combined with a financial crisis,” Mr. Macey said. “The damage done to our financial system is likely to have lingering effects, one of which is hampered credit creation and relatively tepid loan demand, which in turn could dampen the rate of future growth.”
Looking internationally, and consistent with the view it has held in recent years, Wilmington Trust sees the greatest potential for excess equity returns over the next several years in emerging markets. “As was the case when we released our long-range forecast early last year, emerging markets continue to present a compelling combination of attractive valuations with relatively greater prospects for growth compared with more established global markets,” Mr. Macey said. “Developing markets like China and India are showing signs of decoupling from the U.S. economy, which should help insulate them from downdrafts they may otherwise experience from the struggling U.S. economy.”
Wilmington Trust also believes that marginal tax rates are headed higher, which favors municipal bonds. While investors have been drawn to bonds of late, Mr. Macey cautions investors that an important factor generally favoring bonds – namely, falling interest rates – is not likely given today’s low prevailing rates. While rates may not move significantly in the near term, their likely future direction as the economy improves is higher, Mr. Macey said. He strikes another note of caution with domestic stock valuations. “A year ago, when the markets were gripped by fear and deteriorating fundamentals, valuations were much cheaper,” he said. “While fundamentals have improved, stock prices have risen at a faster rate, erasing the cheapness we saw last year. As a result, our forecasts for stocks are substantially below what we predicted at this time last year.” Indeed, Wilmington Trust’s long-term forecast calls for high-yield bonds to outperform stocks, and with less risk.
To help mitigate risk, Wilmington Trust encourages qualified investors to consider allocations to hedge funds, despite their drawbacks. “Hedge funds lack liquidity and transparency and face potentially increased regulation that could limit their strategies, but they also provide attractive risk/return characteristics because they face less competition to achieve relative outperformance than many asset managers,” Mr. Macey said. “This is an important consideration given our expectation for single-digit returns.”
