Moving beyond market episodes to build scenarios for asset allocation

Among the range of investment choices that are made building portfolios, asset allocation decisions are some of the most consequential. The longer-term nature of these decisions contributes to their outsized importance, but many of the widely-used investment analytics and frameworks are implicitly or explicitly short-term in nature.

An increasingly important tool for asset allocators is scenario analysis, where the standard tools analyse portfolios based on historical episodes. We have discussed the limits of using historical returns to form forward-looking scenarios. Another dimension to this problem, however, is that common themes and historical episodes tend to be relatively short-lived. Classic scenarios on institutional investor lists (e.g. Taper Tantrum 2013, Brexit 2016, COVID 2020, Tariff Shock 2025) occur over windows that fall well short of a multi-year asset allocation horizon. Going beyond existing scenario tools requires a new modelling approach.

A decomposition lens on historical performance

The importance of allocation decisions can be illustrated by examining the relative performance of key asset classes and segments that compound across multiple years. One of the most commonly cited divergences in performance is the comparison of US and European equities in the early 2010s.

The Euro Stoxx 50 delivered a price return of roughly 1.8% annualised over the 2010s, around 20% cumulative over the full decade. Including dividends, a Euro Stoxx investor earned around 5% (annualised) — a reasonable-sounding number until you place it next to the S&P 500's approximately 14% annualised return over the same period.

Before building forward-looking scenarios, we can break down the European performance to better understand the origins of this underperformance. Our present-value approach gives us a way of understanding what drove the European equity 'lost decade'. Realised returns can be expressed in terms of what was expected at the outset — the return an investor would have earned if everything came in as priced — and a set of shocks: dividends that arrived versus what was expected, revisions to expected future cash flows, and changes in discount rates over the period.

For the Euro Stoxx 50 over the 2010s, weak returns partly played out through dividends per share (capturing investor cash flows and weak buyback activity through higher share counts). At the beginning of 2010, the expected DPS path — reflecting what was priced into the market at that point — implied steady growth of roughly 5-6% per year, reaching around 190 by 2020. The realised path ended the decade at 124 — barely above where it started. During 2011, there was a negative shock to cash flows as the sovereign debt crisis hit. By early 2012, realised DPS actually increased above the original expected path. An investor could have reasonably concluded that the shock was temporary. But in 2013, as the Eurozone failed to generate a self-sustaining recovery, DPS flattened again and the gap versus expected opened up.

In addition to cash flow paths, we can understand the path of returns in terms of shifting expectations. The charts below compare the term structures of expected cash flow growth and discount rates for the Euro Stoxx 50 at the start of 2010 and the end of 2019. On the left-hand chart, the downward revision in cash flow expectations is visible across the entire horizon — long-term expected growth roughly halved over the decade, from around 4-5% to 2-2.5%. The highlight of the lost decade was a slow downward drift in the long-horizon dividend growth expectations that put a persistent drag on equity prices over this period.

On the right-hand chart, we can see that discount rates collapsed. In 2010, the market was discounting Euro Stoxx cash flows at roughly 7-8% across horizons. By 2019, that had fallen to 2-5%, reflecting a combination of lower inflation expectations and a near-zero or negative term premium driven by ECB bond purchases. This compression in discount rates provided significant support to equity valuations — but it was not enough to offset the persistent downward revisions to expected cash flows. The net result was a decade of returns that, while positive in absolute terms, fell far short of what was priced in at the outset and far short of what was available elsewhere. In addition, lower discount rates also feed into lower expected returns, meaning the prospects for making up lost ground in European equities became harder.

The European lost decade was not just an equity story. Euro area government bonds benefited from the same decline in real rates that partially supported equities, delivering solid returns as yields fell to historic lows. Euro credit similarly performed well on a spread compression basis. We will add a cross-asset performance table for Euro-denominated assets over the period in a future update.

Forward-looking scenarios

Looking forward from today, the stakes can seem higher than ever when allocating across different geographic regions, across public and private assets, and across many other dimensions. As market, economic, and geopolitical regimes shift, asset allocation choices are likely to be even more consequential.

The decomposition of equity returns helps clarify how a lost decade can come about, and highlights the need to think in terms of multi-year impacts when building scenarios. In particular, when thinking in present-value terms, it forces us to recognise that there is a path of expected cash flows priced into any equity market today. If those cash flows materialise as expected, you earn the expected return.

A lost decade, almost by definition, is a scenario where outcomes are worse than anticipated. But to think through it clearly, you need to know what was priced in, and then trace how reality deviated from those expectations. It also implies that there is compensation attached to risk, in the form of expected returns. This may seem trivial, but when it comes to building portfolios, the level of this compensation, the cash flow paths that would generate this compensation, and the scenario impacts relative to the compensation are essential building blocks.

Using our scenario framework, an investor can take the pattern of shocks from the Euro Stoxx 2010s — the initial large negative shock, the partial recovery that fails, the subsequent grind of persistent downside disappointments — and apply a similar profile to a different market. The natural candidate today might be US equities, where long-term growth expectations are elevated and equity risk premiums are historically thin, as we have discussed previously. One important aspect that makes this more than a mechanical replay of history is that starting points matter. The Euro Stoxx in 2010 had a very different valuation, growth outlook, and risk premium configuration than US equities today.

Crucially, the scenario does not stop at equities. Because each shock is expressed through the underlying drivers — cash flow expectations, discount rates, and risk premia — it propagates consistently across rates, credit, and currencies, so the allocator sees the portfolio-level impact rather than an isolated equity hit.

A lesson from the European lost decade is that multi-year outcomes are driven by the accumulation of shocks and revisions to expectations. A scenario framework built around those drivers and mapped consistently across asset classes gives allocators a way to build scenarios for their portfolios that move beyond using historical episodes.