Looking at what the next five years could hold for investors Pictet Asset Management’s Luca Paolini argues that we will see a number of investment trends reverse, change and become completely different. 
Pictet’s chief investment strategist said that, while its five-year outlook holds similarities to the previous years the differences will be critical for investors.
The first, is that after a run of 17 per cent return per annum since 2009 the US equities market is now the weakest globally.
He said: “The US is now the most vulnerable equity market. This is probably the best time ever, for investors to diversify away from the US.
“When I go to the US I am shocked to know that most of our clients, and everybody I speak to, tend to invest only in the US. And actually, in the past, this was a good strategy. But I think it's going to be a very bad strategy for the next five years.”
Using his ‘Paolini rule’ calculation, the strategist sees long-term equity returns depend upon earnings growth, initial valuation and monetary policy.
This, he said, provides a reliable forecast for real equity returns over the next five years.
US equity returns well below average in the next five years
Source: Datastream, Pictet Asset Management, as of 30 April 2019
All three inputs are currently pointing towards the US equities market looking worse than ever for investors, as the above chart shows.
The reason for this trend is two-fold, according to Paolini.
The first is that because the current business cycle is coming to an end – as suggested by the inverted US Treasury yield curve – he argues that this is pushing the US closer to a recession within the next three years as total debt tops levels seen during the global financial crisis.
He said: “If you think that the yield curve is still a good indicator, then the next five years going to be very difficult for US equities.
"There's been a lot of deleveraging in some parts of the economy like the US consumer, but actually if you look at total debt it is now higher than it was in 2009. Actually, there is more debt not less."
Paolini’s second reason for a weaker US market is that the dollar is too expensive. Having been overvalued by 15 to 20 per cent it should now start to devalue against other global currencies, possibly going down by 10 per cent over next 10 years,” he said.
The strategist added: “The devaluation of the dollar is purely cyclical, and I think it is very vulnerable to any kind of sign that the economy may actually enter a recession. I think this is more likely than not in the next two or three years “
“The dollar, contrary to what most people believe, has been in a secular downtrend, since the 1970s. We feel that the dollar is not the safe currency most people think it is.”
US dollar trade-weighted index and relative growth of US versus rest of world.
Source: Datastream, IMF forecasts, Pictet Asset Management, as of 30 April 2019
This combination of what Paolini described as “an expensive stock market and an expensive currency,” sits on a backdrop of the narrowing gap between the US growth and the rest of the developed world, further supporting his belief that now is a good time for investors to diversify themselves away from the “weak” US equity market.
As a consequence of the depreciation of the dollar and the poor opportunity-set in US equities Paolini recommends investors look towards emerging markets in the years ahead, particularly Asian equities and emerging market local bonds.
Focusing on Chinese bonds and stocks in particular, the Pictet strategist said that as China’s economic reforms are implemented these will re-rate leading to outperformance.
Although Paolini acknowledges that China’s growth is slowing – dropping to 6-7 per cent growth from 14 per cent in 2007 – he argued that growth will be of superior quality compared to the US, making it an integral asset of investors future portfolios.
In addition to China, Paolini recommends that investors add eurozone exposure which has lagged the US for some years.
He said looking back over the past 10 years, the US has outperformed the eurozone by around 8 per cent, but now that is likely to reverse as three variables go against the US’ favour.
He said: “Let's look at why there was this outperformance, most of what it's all about is US growth being much better than the eurozone.
“Let's look at why there was this outperformance. Most of what it's all about is US growth being much better than the eurozone. But interestingly enough, if you look at per capita GDP, there is no big difference”
“European stocks were traditionally a wild card, but now look in reasonable shape. Notwithstanding the region’s economic challenges and the risk of political fragmentation, the eurozone could be a source of positive surprises. It would be wrong to write it off.”
Other areas that should not be ignored but offer other attractive alternatives to US equities are hedge funds, some real estate markets and commodities.
Private equity, according to Paolini, will disappoint investors over the next five years with returns that trail those of equities.
Paolini added that, another attractive sector that will do well for investors over the coming years would be gold.
“Gold should do especially well,” Paolini said. “Central banks are buying gold a lot. Why? Because they probably feel like we feel that the dollar is not safe currency is most other people think.”
He added that: “When we say gold, we're not saying we're not telling clients put 50% of your pensions gold. But if you have zero per cent, go from zero to five per cent. It make sense because you effectively have an asset class that depends on what a rerates and rerates will not move. Rerates is the opportunity cost of holding gold.
“Gold is very dependent on the dollar negative correlation always been and geopolitical risks.”
Long-term asset classes return forecasts
Source: Datastream. Pictet Asset Management, as of 31st March 2019.
Another major change which the chief strategist says will alter the shape of investors’ portfolios over the next five years is their split between bonds and equities.
According to Paolini, most portfolios are currently split in half: 50 per cent equity markets and the other 50 per cent into bonds.
Historically these portfolios have delivered a return of 5 per cent per annum, but Paolini said that this will plummet down to nothing over the next five-years and will struggle to produce a positive inflation-adjusted return.
He said: “Portfolios are being split 50/50 between market equities and bonds for 5 per cent return in the past five years, after inflation. It’s going to be zero in the next five years.
“Now, obviously inflation is important. So, you actually you start from zero from a global passive 50 per cent equities, 50 per cent government bond. So obviously this is going to be a big change.
“The next five years, then, will require investors to take a long hard look at their portfolios. What proved successful in the past is unlikely to do well in the future.”