Thoughts on the Market

Episode: Rebalancing Portfolios as Risk Premiums Drop

Host: Serena Tang, Chief Cross Asset Strategist, Morgan Stanley
Date: December 22, 2025

Episode Overview

Serena Tang analyzes whether traditional portfolio strategies, particularly the classic 60/40 split between equities and bonds, remain effective amid falling risk premiums and high market valuations. The episode provides data-driven projections on long-term returns across global asset classes, explores the implications of compressed risk premiums for investors, and discusses how optimal portfolio construction is evolving in today’s market environment.

Key Discussion Points & Insights

Market Rally and Return Expectations

• Recent Performance:

  • Global equities have rallied over 35% since April 2025 lows.
  • US high-grade fixed income posted annual returns 5% above the past decade’s average.
  • Raises questions on sustainability of such returns in the future.

    "Global equities have rallied by more than 35% from lows made in April and US high grade fixed income has seen last 12 months returns reach 5% above the averages over the last 10 years." (A, 00:18)

• Projected Long-Term Returns:

  • Global Equities: ~7% annualized
  • S&P 500: 6.8%
  • European & Japanese equities: ~8%
  • Emerging markets: ~4%
  • US Treasuries (10-year): nearly 5%
  • German bonds: nearly 4%
  • Japanese government bonds: nearly 2%

    "Over the next decade we project global equities to deliver an annualized return of nearly 7%...Emerging markets however lag at just about 4%." (A, 00:45)

The Shrinking Risk Premium

• Compression Across Asset Classes:

  • US equity risk premium down to just 2%
  • Emerging markets: actually negative (-1%)

    "In very plain terms, investors aren't being paid as much for taking on risk as they used to be." (A, 01:36)

  • Main driver: Rich valuations—particularly in the US.

• Valuation Context:

  • S&P 500’s cyclically adjusted P/E near dot-com bubble highs.
  • However, underlying fundamentals have significantly improved:
    • Companies are more profitable.
    • Free cash flow is nearly 3x higher than in 2000.

    "While valuations are rich, there is some justification for it." (A, 02:09)

Shifting Portfolio Efficiency

• Flatter Efficient Frontier:
  • "The best possible return for any given level of portfolio risk, has shifted. It's now flatter and lower than in previous years." (A, 02:31)
  • Taking more risk no longer boosts returns as much as before.

The 60/40 Portfolio: Does it Still Make Sense?

• Recent Performance:

  • Strong rebound post-2022, delivering above-average returns for 3 years straight.

• Forward-Looking Outlook:

  • Expected annual return for 60/40 portfolio: ~6% (vs. historical ~9%)

    "Looking ahead, though, we expect only around 6% annual returns for a 6040 portfolio over the next Dec. Versus around 9% average return historically." (A, 03:17)

• AI and Correlations:

  • Advances in AI may drive deeper synchronization between stocks and bonds—reducing the diversification benefits.
  • Investors may need to increase equity exposure beyond traditional 60/40.

    "If that happens, investors might benefit from increasing their equity allocation beyond the traditional 6040 split." (A, 03:40)

• Key Takeaway:

  • Optimal asset allocation is not static and should adapt to changing market dynamics.

    "The 6040 portfolio isn't dead and optimal multi asset allocation weights are evolving and so should you." (A, 04:36)

Notable Quotes & Memorable Moments

• On Risk Premiums:

  "Investors aren't being paid as much for taking on risk as they used to be." (A, 01:36)

• On Equity Valuations:

  "S&P 500's cyclically adjusted price to earnings ratio is near the highest level since the dot com bubble. But the quality...has improved dramatically." (A, 01:51)

• On Portfolio Construction:

  "The efficient frontier...is now flatter and lower than in previous years, so it means taking on more risk in a portfolio right now won't necessarily boost returns as much as before." (A, 02:30)

• On Dynamic Strategy:

  "It's important to realize that the optimal mix of stocks and bonds is not static and should be revisited as market dynamics evolve." (A, 03:54)

Timestamps for Key Segments

• 00:18 – Recent Market Rally & Return Context
• 00:45 – 10-Year Asset Class Return Projections
• 01:36 – Risk Premium Compression
• 01:51 – Valuation Justifications (S&P 500 quality)
• 02:30 – Efficient Frontier & Risk/Return Dynamics
• 03:13 – The 60/40 Portfolio: Current and Projected Performance
• 03:40 – Role of AI and Equity/Bond Correlations
• 03:54 – Adaptive Asset Allocation in a Changing Market
• 04:36 – Closing Insights: Evolving Portfolio Weights

Summary

This episode emphasizes that while traditional portfolio strategies like the 60/40 mix are not obsolete, they require a thoughtful, adaptive approach as risk premiums compress and market dynamics shift. With lower forward-looking returns, diminished risk premiums, and increased correlation potential between equities and bonds (possibly fueled by AI), investors should regularly reassess their portfolio allocations rather than relying solely on past formulas. The decisive message: Evolve with the markets to optimize risk and return in the coming decade.