Expensive stocks, an expensive dollar and a shrinking growth gap relative to the rest of the world mean the U.S. is on its way out as a spearhead for investors, according to Swiss multinational private bank Pictet.
In a presentation in London this week, Pictet Asset Management Chief Strategist Luca Paolini told reporters that for these reasons, U.S. stocks will deliver returns that only marginally exceed inflation over the next five years.
"This is probably the best time ever for U.S. investors to diversify away from the U.S." Paolini said.
He added that investing only in U.S. equities is going to be a "very bad strategy for the next five years" in part because "the U.S. is close to a recession," and partly because both the dollar and stocks are overpriced.
Paolini contended that the dollar is overvalued by around 15-20% and will therefore "steadily decline against most currencies."
So where to?
While traditionally considered a "wild card," Pictet analysts believe the euro zone could be a source of "positive surprises" despite the region's economic and political challenges.
"Among alternatives - hedge funds, some real estate markets and commodities - especially gold- should do well," Paolini suggested, adding that private equity will disappoint over the next five years.
He also made the case for emerging market assets, particularly in Asia, predicting China's stocks and bonds will re-rate as the country's economic reforms translate into financial performance.
"China's growth will slow from the heady pace of recent decades, but it will be of superior quality," he said.
"At the same time, Beijing increasingly needs to attract foreign capital, not least to make up for reduced saving by an ageing population."
With Chinese assets becoming integral to worldwide investment portfolios, on account of their diversification opportunities given their low correlation to other developed markets, Pictet expects the renminbi's international footprint to grow.
As part of their fixed income allocation, Paolini advocated for investors taking more risk and 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," he added.
Diversification
Pictet projects that over the next five years, a portfolio with a 50/50 split between developed market equities and government bonds, which has historically delivered an annual real return of 5%, will "struggle to deliver a positive inflation-adjusted return."
This is because initial valuations are too high, and radically lower corporate tax rates are expected to come under pressure. Paolini highlighted that U.S. corporate tax rates were around 15% lower than after the crisis in 2009.
Pictet analysts calculated that 20% of the increase in net corporate earnings from 2009 are due to the tax cuts enacted by President Donald Trump in 2017, which Paolini suggested explained the outperformance of U.S. equities, while liquidity is shrinking.
Inflation-adjusted return shows return on an investment after removing the effects of inflation. Removing inflation from the return of an investment reveals the true earning potential of a security without external economic forces.
"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," Paolini concluded.