Article

Are we there yet? Multi Asset’s Long Term Return Expectations

September 2023

Key Points

  • The Multi Asset Team expects inflation to fall closer to central bank targets in the next few years
  • Developed market bonds should provide a hedge against slow growth in the interim, and emerging market bonds are likely to offer higher rewards
  • Energy transition infrastructure and logistics-related real estate also offer investment opportunities

All investment strategies have the potential for profit and loss, capital is at risk. Past performance is not a guide to future returns.

Concerns over inflation are abating as expected, but central banks around the world remain cautious in signalling the all clear. This is because inflation spiked so much and remained high for a prolonged period. Indeed, central banks are acutely aware that easing policy too early could raise longer-term inflation expectations, making it even more difficult to bring inflation back to the typical target level of around 2 per cent.

The post-pandemic surge in demand for goods and services, triggered by exceptional fiscal support at a time when there was limited ability to spend, has ended. The supply side has also recovered as bottlenecks have eased and people around the world have been able and willing to return to work.

This normalisation has fed through to lower prices for goods relatively quickly. In the US, for example, the prices of used cars and major kitchen appliances have fallen notably from their post-pandemic peaks. But it is the services side of inflation that remains a problem, where prices are inherently more ‘sticky’ as they are closely linked to wages.

When we do see the effects of recent monetary policy action, we expect slower economic growth to lead to rising unemployment in the near term, which will dampen wage inflation and bring it closer to levels that are compatible with central bank inflation targets.

Another important contributor to the steady fall in global inflation this year has been lower energy prices. The Russian invasion of Ukraine put massive upward pressure on energy markets, but a relatively mild winter and proactive approaches from energy importers created a considerable inventory buffer that has driven energy prices, particularly natural gas, much lower. In the medium-to-longer term, Russia’s actions and the associated spike in energy prices have sped up the energy transition in both supply (switching to renewable sources) and demand, where electric vehicle sales continue to surge.

At the time of writing, headline inflation stands at about 8 per cent in the UK and just over 3 per cent in the US, much lower than our last update when these figures were 11 per cent and 8 per cent respectively.

Our central view is that inflation will drop back towards central bank targets in the short-to-medium term. We expect consumer demand and supply pressures to continue to ease, although labour market tightness and continued wage inflation pose the most significant risks to the contrary.

You can read more about our cyclical and thematic thinking via our Long Term Returns Expectations (LTRE) hub. In addition to some shorter articles, it features longer reads on how we pick winners in the property market, why we believe industrial automation will help tame price rises and why productivity may be about to get a boost after years of missing expectations.

In this summary table, and at the end of each asset class section, we have rounded our forecasts to the nearest 0.25%. This permits sufficient distinction between asset class returns while avoiding spurious accuracy in our forecasting. Consequently, there may be some instances in which numbers quoted in the text do not exactly add up to the stated forecast.

Growth

We continue to forecast average inflation-adjusted growth for major developed economies (the US, Eurozone, Japan and the UK) to be 1.25 per cent over the next 10 years. As we expect the labour force to stagnate due to ageing population and lower immigration, almost all of this comes from productivity growth. This is modestly higher than seen in the last decade, though well below the levels experienced during the productivity surge of the 1990s.

For the emerging world, excluding China, we forecast real growth of 3.25 per cent, with more rapid population growth contributing 1.25 per cent, and productivity 2 per cent.

We expect China’s economy to slow over the next decade but still register a respectable 3 per cent real growth rate. The shift will follow its transition from an investment-led economic model to one oriented toward domestic consumption.

Inflation

As noted, we expect inflation to fall towards central bank targets over the next decade. The reasons for this include:

  • Central banks remain determined to return inflation to their respective targets. Their interest rate increases should curb demand.
  • Lower asset prices will likely reduce consumer wealth and hence consumption.
  • Supply shortages have eased. Some industries that saw constrained capacity, such as semiconductors and shipping, may well move into oversupply in the medium term.


As demand abates and supply pressures ease, we think prices will rise at a more moderate pace. Although still uncertain, some central banks have moved to Average Inflation Targeting (AIT), which means any over/under target inflation results in central banks desiring the opposite in future years.

Because of the high inflation we have seen, central banks might therefore want to see below target inflation for a time. Acknowledging this, our average 10-year forecasts have been reduced closer to target.

For example, in the US, we expect annual consumer price inflation (CPI) to fall from its current 3 per cent rate to below its longer-term target of 2 per cent, before returning to target for the rest of the decade. That produces an average 10-year inflation figure of 2.1 per cent.

Using the same approach gives us expected inflation of:

  • 2.3 per cent in the UK
  • 1.9 per cent in the Eurozone
  • 1.25 per cent in Japan
  • 2 per cent in China
  • 3.75 per cent in emerging markets outside China


We recognise that this scenario may be wrong, especially given some of the forces that might give rise to higher inflation. These include:

  • A shift in political and central bank attitudes, which could lead to inflation targets being de-prioritised or raised.
  • More fiscal spending, such as increased defence and infrastructure spending.
  • Demographic change, where labour participation rates fall, tightening labour markets and raising wage inflation.

 

Policy rates

We expect policy rates to be at or close to a peak in most markets. They will begin to fall as inflationary pressure eases, leading to a risk of higher yields for longer. But in thinking about their future trajectory, we place greater weight on factors such as the large global savings stock.

We expect the significant rise in policy rates to be a relatively short-term phenomenon. We think the US policy rate is very close to its peak at 5.5 per cent, but over the decade it should settle at its neutral level of 2 per cent.

Similarly, while more policy tightening in the Eurozone and UK is very plausible in the short term, we expect cash rates to finish the decade at significantly lower levels than they currently are: 1 per cent and 2.5 per cent, respectively.

 

Asset class outcomes

Following the rise in yields, we continue to think developed market government bonds should generate positive and diversifying returns versus cash in the years to come. The path of policy rates implied by yield curves is, quite simply, too high. So, we expect bond yields to fall from current levels as market concerns about inflation decrease.

For example, in the US, we forecast that the 10-year yield will settle at 2.25 per cent by the end of the decade versus being more than 4 per cent at the time of writing. Bonds should earn a positive return if the market’s expectation converges toward ours. In the case of the US, this amounts to 1.8 per cent above cash per annum.

The prospect of positive returns makes government bonds more attractive to a multi-asset portfolio, where they offer a potential hedge against any slowdown in economic growth. That’s provided, of course, that inflation abates as we expect.

We are enthusiastic about emerging market local currency government bonds, where we forecast a 10-year return of 3.5 per cent above cash. Central banks in the emerging world have raised rates sharply due to increased inflation. We think they will have room to cut them over the next few years as inflation subsides.

Similarly, we think hard currency emerging market bonds can perform well from elevated spreads, which we believe overstate long-run credit risk. We forecast a return of 5.75 per cent above cash.

In credit markets, spreads above risk-free rates are higher than our estimate of their long-run fair value level. We expect that to lead to good outcomes, boosted by above-cash returns from the underlying government bonds. For example, we expect high yield credit to deliver 5.25 per cent and cross over investment grade credit (BBB/BB rated) to earn 3.5 per cent over cash.

Similarly, we think spreads in the structured finance market reflect more default risk than will materialise. We expect this asset class to deliver good long-term returns. In the case of mezzanine bonds, we project a return over cash of 7.25 per cent per annum over the next 10 years.

Recent increases in equity markets have made them less attractive. We forecast that returns over the next decade from a global, passive portfolio of 3 per cent above cash will still be lower than the very long-run expected outcome of 3.75 per cent.

Part of this is because corporate profit margins have moved to historically high levels, especially in the US. To be clear, we do not expect a sharp reversal to historical averages. Indeed, we think there are many companies in the US and elsewhere capable of sustaining high margins for many years. But we believe it will be difficult for the whole market to continue generating this profitability level over the very long term. Our forecast, therefore, anticipates a modest degree of future margin compression.

In property, our expected returns are higher than equities, at 6.5 per cent over cash. We expect good outcomes from logistics property in particular. The sector should benefit from growth in ecommerce and the lack of adequate warehouse supply in many regions.

In infrastructure, we think the transition from fossil fuel-based generation to new forms of energy provides a significant growth opportunity for both regulated utilities and renewable energy developers and operators. This underpins our 10-year forecast of 5.5 and 6.75 per cent returns over cash for core and economic (renewable developers) infrastructure respectively.

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