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This update focuses on our 5-year baseline expected geometric returns and examines four potential inflation and growth scenarios.

�۶��Ƶ AM’s Views

Global equities continue to be expensive on an absolute basis. On a relative basis, they still offer value over cash and inflation, assuming inflation to be around targets set by central banks. Some individual markets (Japan, Europe) are undervalued and offer some of the best expected returns over the next five years.
Expected government bond returns in developed markets are higher now than six months ago.
The US dollar’s retreat leaves the currency closer to fair value. Going forward, we see limited gains from currency exposure for unhedged non-USD assets in USD terms.
We explore how inflation risks should influence positioning. Conservative investors that need to protect real purchasing power in the short run (a retiree on a tight budget) will likely invest differently than investors that have long time horizons.
- Longer term investors should overweight equities, real estate and a lower bond duration profile.
- Shorter term investors should tilt toward short duration inflation-linked bonds, short-term corporates and floating rate notes. Equities offer little inflation protection in the short run, but probably do well relative to other asset classes. Real estate and commodities should help manage inflation risk in the short run.

Part I: Capital market update

Our inflation estimates have moved up slightly, though not as dramatic as changes in break-even rates imply. Although we see short-run inflationary pressures, we expect central banks to be successful in controlling inflation.

Here is a global summary of expected returns as of June 2021.

With equities rallying 15.1%¹ since November, we believe that valuations are even more stretched and require extraordinary earnings growth and continued low rates to be justified.

In general, with the US dollar close to fair value, we see limited gains from currency exposure for unhedged non-USD assets in USD terms. Conversely, we see smaller losses for foreign investors investing in USD denominated assets.

¹ MSCI AWCI in USD from 30 Nov 2020 to 30 June 2021 (seven months).

Five Year Expected Returns in USD terms Annualized %

Asset class	Asset class	May 2020	May 2020	Nov 2020	Nov 2020	June 2021	June 2021
Asset class	Global Equities Unhedged	May 2020	7.5	Nov 2020	6.5	June 2021	4.9
Asset class	Global Gov Hedged	May 2020	-0.1	Nov 2020	-0.1	June 2021	0.8
Asset class	Global Corp IG Hedged	May 2020	1.1	Nov 2020	0.2	June 2021	0.7
Asset class	Global Corp HY Hedged	May 2020	4.1	Nov 2020	1.8	June 2021	1.5
Asset class	3-mo T-Bills	May 2020	0.2	Nov 2020	0.3	June 2021	0.7
Asset class	US Consumer Inflation	May 2020	1.4	Nov 2020	1.6	June 2021	2.1

Part II: Inflation and capital market expectations—A look at four scenarios

One of the biggest market concerns is a sustained bout of disruptive inflation. For at least a decade, the global economy has had inflation below central bank targets.² Heightened concerned that this can reverse is warranted, given the scale of the fiscal and monetary policy stimulus in response to the pandemic. This could cause a rapid period of above-trend growth that outstrips economies’ productive capacity, resulting in inflationary pressures, which could be further perpetuated by workers demanding increasingly higher pay to keep up with these higher prices.

Four potential inflation scenarios

We quickly explore four different inflation scenarios. In each of these scenarios we are assuming a continuation of growth and above-average inflation in the second half of 2021. Thus, the negative and positive effects begin to show themselves in early 2022.

Baseline: Moderate growth and moderate inflation.
Growth Inflation: Strong growth and high inflation
Stagflation: Low growth and inflation at 3.1%
Stagnation: Recession in late 2022 followed by low growth and low inflation.

² For example, since 2009, the Fed has targeted 2.0% inflation on a Core PCE basis. However, Core PCE has averaged about 1.6% over this period. The 'headline' inflation figure (CPI-U All Items) has been a bit higher at 1.8%.

5-yr Expected Real Returns by Scenario

Source: �۶��Ƶ Asset Management as of 30 June 2021.

Five-yr. expected real returns by scenario. Table shows �۶��Ƶ Asset Management’s expected five year real returns for a variety of asset classes under four potential scenarios: Inflationary growth, Base case, Stagflation and Stagnation.

Part III: Applications to portfolios: Few places to hide

When we look at portfolios, we start with a simple 60/40 portfolio, which in this case is 60% US equities, 20% 10-year Treasury and 20% broad credit. We now look at a set of possible portfolio moves to deal with inflation risks.

Expected returns for sample portfolios

Asset class	Asset class	US 60/40	US 60/40	Shorten Duration	Shorten Duration	Diversify FI	Diversify FI	Diversify All	Diversify All
Asset class	US Large Cap Equity	US 60/40	60%	Shorten Duration	60%	Diversify FI	60%	Diversify All	50%
Asset class	1-3 yr Treas	US 60/40	0%	Shorten Duration	0%	Diversify FI	0%	Diversify All	0%
Asset class	1-3 yr TIPS	US 60/40	0%	Shorten Duration	10%	Diversify FI	10%	Diversify All	10%
Asset class	1-3 yr Credit	US 60/40	0%	Shorten Duration	10%	Diversify FI	10%	Diversify All	10%
Asset class	10-yr Treasury	US 60/40	20%	Shorten Duration	10%	Diversify FI	10%	Diversify All	18%
Asset class	10-yr TIPS	US 60/40	0%	Shorten Duration	0%	Diversify FI	0%	Diversify All	0%
Asset class	US Inv Grade Credit	US 60/40	20%	Shorten Duration	10%	Diversify FI	10%	Diversify All	0%
Asset class	US High Yield Credit	US 60/40	0%	Shorten Duration	0%	Diversify FI	0%	Diversify All	2%
Asset class	Commodities	US 60/40	0%	Shorten Duration	0%	Diversify FI	0%	Diversify All	2%
Asset class	Gold	US 60/40	0%	Shorten Duration	0%	Diversify FI	0%	Diversify All	3%
Asset class	Real Estate	US 60/40	0%	Shorten Duration	0%	Diversify FI	0%	Diversify All	5%
Asset class	Real Assets	US 60/40	0%	Shorten Duration	0%	Diversify FI	0%	Diversify All	0%
Asset class	Cash	US 60/40	0%	Shorten Duration	0%	Diversify FI	0%	Diversify All	0%
Asset class	Total	US 60/40	100%	Shorten Duration	100%	Diversify FI	100%	Diversify All	100%

Nominal Terms	Nominal Terms	US 60/40	US 60/40	Shorten Duration	Shorten Duration	Diversify FI	Diversify FI	Diversify All	Diversify All
Nominal Terms	Inflationary Growth	US 60/40	4.3%	Shorten Duration	4.5%	Diversify FI	4.5%	Diversify All	4.2%
Nominal Terms	Base	US 60/40	1.9%	Shorten Duration	1.9%	Diversify FI	1.9%	Diversify All	1.8%
Nominal Terms	Stagflationary	US 60/40	-0.6%	Shorten Duration	-0.4%	Diversify FI	-0.4%	Diversify All	0.0%
Nominal Terms	Stagnation	US 60/40	0.0%	Shorten Duration	-0.2%	Diversify FI	-0.2%	Diversify All	0.0%
Nominal Terms	Average	US 60/40	1.4%	Shorten Duration	1.4%	Diversify FI	1.4%	Diversify All	1.5%
Nominal Terms	Range	US 60/40	4.8%	Shorten Duration	5.0%	Diversify FI	5.0%	Diversify All	4.2%

Real terms	Real terms	US 60/40	US 60/40	Shorten Duration	Shorten Duration	Diversify FI	Diversify FI	Diversify All	Diversify All
Real terms	Inflationary Growth	US 60/40	1.1%	Shorten Duration	1.3%	Diversify FI	1.3%	Diversify All	1.1%
Real terms	Base	US 60/40	-0.1%	Shorten Duration	-0.2%	Diversify FI	-0.2%	Diversify All	-0.2%
Real terms	Stagflationary	US 60/40	-3.6%	Shorten Duration	-3.5%	Diversify FI	-3.5%	Diversify All	-3.1%
Real terms	Stagnation	US 60/40	-1.4%	Shorten Duration	-1.6%	Diversify FI	-1.6%	Diversify All	-1.5%
Real terms	Average	US 60/40	-1.0%	Shorten Duration	-1.0%	Diversify FI	-1.0%	Diversify All	-0.9%
Real terms	Range	US 60/40	4.7%	Shorten Duration	4.8%	Diversify FI	4.8%	Diversify All	4.1%

Source: �۶��Ƶ Asset Management as of 30 June 2021.

Conclusion

The run-up of equities in the last few months continues to pull some future returns into the present. Our expected returns for equities—especially US equities—are the lowest in years. Pockets of equities outside the US offer more compelling expected returns.

Conversely, the rise in government bond yields has improved expected returns in sovereign bonds.

When it comes to asset returns and inflation, we see that the market is little prepared for a sustained breakout of price pressures. A disruptive repricing of inflation risks will affect all markets—in the short-run there is no place to hide from negative real returns.

Market positioning should also anticipate what type of inflationary environment that we will see. If this is a reopening bout of inflation caused by pent-up savings and supply chain bottlenecks, equities and real estate should continue to generate positive real returns while fixed income is devastated. On the other hand, a Stagflation environment mildly reminiscent of the 1970s will cause all assets to suffer. Inflation indexed bonds will offer some degree of protection, but still lock in negative real returns.

We expect alternatives to suffer the least as commodities, gold and real estate gain relative to other asset classes. Again, the nature of inflation will be important. Inflation tied to a more robust growth backdrop should benefit real estate, while a Stagflation would probably be very positive for gold. Commodities would probably be one of the drivers in inflation and clearly should do better in an inflationary growth environment.

In short, we believe that the market opportunities to truly profit from inflation are few.

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