Higher yields, lower valuations and partial normalisation of policy settings means investment market return expectations are better than they have been for years, says Zenith head of asset allocation, Damien Hennessy.

“The forward expectations for returns for cash, credit and bonds in particular are all far better than they have been for a long time, as their starting point valuations have improved,” Mr Hennessy says.

“A year ago, our long-term return expectations for bonds were around 1.5-2 per cent and for credit, below 3 per cent. Now we are projecting 4 per cent for bonds and closer to 5.5 per cent for credit. For typically defensive assets, that’s a big uplift in performance.”

The 2022 year was the worst in over a century for a standard 60/40 portfolio – and bonds experienced one of their worst years on record – but there’s reason to be more optimistic, Hennessy says, with the key factor being at what level inflation settles and what becomes the ‘normal’ level of interest rates.

“We do expect higher volatility than what we have experienced over the past decade given higher rates and inflation, less supportive liquidity settings and the likelihood of a more volatile business cycle.

“However, if inflation has peaked, and the negative correlation that markets have historically exhibited with shares and bonds reasserts itself, portfolios should prove much more robust going forward,” Hennessy says.

Zenith’s head of consulting Steven Tang said their return expectations for global equities, including small caps and emerging markets, have also improved while the diversification benefits of unhedged global equities continue to shine through.

“Portfolio return assumptions for a 60/40 traditional balanced portfolio are looking better than they have since 2015. As for what that means for optimal portfolio construction going forward, the higher return expectations will lead to allocating more to bonds and higher-grade credit.

“There will be tactical calls on bonds, but at least real and nominal bond yields are much closer to fair value. Within the higher-risk portfolios where equity weightings are heavier, higher allocations to global small caps and mid-caps may be warranted.

“These are the asset classes or sub sectors that have sold off the most over the past 12 months or so, and once the threat of higher inflation and rates and recession risk recede, upside potential will emerge.

“Australian equities didn't suffer the same downturn as other equity markets in 2022. Although the structure of the domestic market has proven favourable in a rising inflation and interest rate environment, and we maintain a healthy weighting to Australian equities, there is a point at which interest rates start to act as a headwind.”