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The era of US leadership is coming to an end

Luca Paolini, Chief Strategist at Pictet Asset Management, tells IFA Magazine why the era of US leadership is coming to an end.

“The US is an expensive stock market, an expensive currency and the country’s growth gap relative to the rest of the developed world is shrinking. For these reasons, US stocks will deliver returns that are only marginally above inflation over the next five years.

“This means that now is a great time to diversify away from US equities. The question is, where to?

“European stocks, traditionally a wild card, look in reasonable shape. Notwithstanding the region’s economic challenges and the risk of political fragmentation, the euro zone could be a source of positive surprises. It would be wrong to write it off.

“Among alternatives, hedge funds, some real estate markets and commodities, especially gold, should do well. Returns from private equity, meanwhile, will struggle to match those delivered in previous years.

Emerging

“Emerging market assets look attractive, especially in Asia. We expect China’s stocks and bonds to re-rate as the country’s economic reforms translate into financial outperformance.

“China’s growth will slow from the heady pace of recent decades, but it will be of superior quality. At the same time, Beijing increasingly needs to attract foreign capital, not least to make up for reduced saving by an ageing population.

“As Chinese assets become an essential part of investment portfolios around the globe, the renminbi’s international footprint status will inevitably grow.

“Within fixed income, developed market corporate bonds look particularly vulnerable. Bond yields are still largely below inflation and corporate leverage at record highs.

More risk

“As part of their fixed income allocation, investors should take on more risk to generate positive returns; this will mean investing more in emerging market debt.

“With many traditional asset classes set to generate below average returns over the next five years, currencies will become a key source of alpha.

“After reaching a point where it is overvalued by some 15 to 20 per cent, the dollar will steadily decline against most currencies.

“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.

Real return

“A portfolio whose investments are split 50-50 between developed market equities and government bonds has historically delivered a real return of 5 per cent per year.

“Over the next five years, that same allocation will struggle to deliver a positive inflation-adjusted return.

“Beating inflation over the long run will require investors to build a more diverse portfolio, one in which emerging market assets, gold, hedge funds and other alternative assets feature much more prominently.

“It’s time to adapt to a different investment landscape.”

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