Market watchers are warning investors to prepare portfolios for an era of lower equity returns as a combination of rising rates, uncertain growth and steep valuations threatens curtain time for the record returns of the recent past.

Index giant Vanguard cut its return projections for Australian equities in late December, forecasting local markets will eke out between 3.5% and 5.5% over the next decade—versus the 10% averaged by the Morningstar Australia index over the past three years. Asset manager Schroders expects mid to low single digits for the ASX.

The outlook is grimmer for US equities. Vanguard sees an average of no more than 4% annually on Wall Street, where returns averaged 25.9% over the last three years.

Analysts are concerned by the balancing act ahead of policymakers in 2022: removing stimulus fast enough to rein in inflation without hitting the brakes on an economic recovery already easing off the breakneck pace set post-pandemic.

Central banks are aiming for the 'Goldilocks scenario' of maintaining growth and containing inflation, but a range of issues from supply chain bottlenecks to tight labour markets could force them to act faster than markets anticipate, says Joe David, global chief economist at Vanguard.

“While the economic recovery is expected to continue through 2022, easy gains in growth from rebounding activity are behind us, and policy will replace health as the leading consideration for investors,” says David.

The trapeze act is already underway in the US where the Federal Reserve is signalling three rate hikes in 2022. Derivatives markets are pricing the first to hit in March.

At home, the Reserve Bank maintains rate increases are years away. Markets are less certain. The RBA bowed to pressure in October and abandoned its policy of pegging 3-year bond yields to the cash rate. Fixed term mortgages at major banks rose in response.

Australian growth should buck the global slowdown in 2022 as the economy rebounds from last year’s lockdowns. Analysts are balancing this against the risks of a hit to iron ore exports from a further downturn in Chinese property and de-carbonisation efforts in the world’s second largest economy.

Room for error is limited with equity markets starting the year at sky-high valuations. Danger signs are flashing that sections of the local bourse are already in bubble territory, says Martin Conlon, head of Australian equities at Schroders.

“A lot of areas of the stock market have degenerated into gambling now,” he says.

“We are passing the parcel rather than looking at the fundamental value of a company and how much money it can realistically make.”

Managers continue to back equities

Despite the lower returns and high valuations on offer, rock-bottom yields for fixed interest and cash mean equities remain the main game in town for many investors.

Returns on government bonds in Australia and the US remain at historic lows despite recently breaching pre-pandemic levels after a selloff triggered by rising inflation and forthcoming rate hikes.

Yields move inversely to price. Australian 10-year yields are hovering near 1.8% after breaching 2% in December, the highest levels since 2019. Their US equivalents are also hovering near pre-pandemic levels.

“If you compare equities to credit, for instance, one of the challenges of credit is that there is not a lot of upside left—the recovery has already been priced into the credit spread,” says Simon Doyle, head of fixed income and multi-asset at Schroders Australia.

“If equity markets were to fall, credit would suffer. But if equities do rally there is really not a lot of room for credit to do the same.”

Going beyond growth stocks

Fund managers are staying in equity markets but switching up their bets, with some looking outside the growth and technology stocks that dominated markets post-pandemic.

Value stocks are set for a comeback thanks to the relative strength of the Australian economy as it emerges from lockdowns, according to Reece Birtles, chief investment officer at Martin Currie Australia. With vaccination rates above 90% nationally and further lockdowns unlikely, the fund manager calls reopening “one of the biggest investment themes” across its holdings.

“As the Australian economy does reopen, we expect the wide value spreads will narrow and Value style stocks will again outperform Growth,” says Birtles.

Schroder’s highlights the intersection of infrastructure and health, noting private hospitals are reasonably priced. Underinvestment in the traditional fossil fuel sector also presents opportunities for those willing to underwrite the transition to lower emissions.

Energy is one of the two sectors in the domestic market, along with utilities, trading at a discount to fair value, according to Morningstar’s head of equity research Peter Warnes.

Shares in the energy sector are trading an average 31% discount to fair value versus the 6% premium found across the broader market.

Others are striking a more cautious note. Higher inflation and rising yields are a threat to growth stocks but the balance of risk lies rather with a growth slowdown crimping earnings and hitting cyclicals and value stocks, according to Randal Jenneke, head of Australian equity at T. Rowe Price.

He favours defensive areas of the market such as healthcare, staples and utilities with an eye on Ramsay Healthcare (ASX: RMD), medical device maker Resmed (ASX: RHC), gas utility APA (ASX: APA) and Coles (ASX: COL)

“We believe the impact of slowing growth will be the factor that will matter more to investors in 2022, as inflation concerns start to fade,” he says.