Article

Where are the opportunities? Multi Asset’s long term return expectations

March 2024 / 7 min

Key Points

  • The Multi Asset Team expects inflation to fall towards central bank targets and economic growth to increase due to industrial policy and the use of AI
  • Given a rapid repricing of interest rate expectations at the end of 2023, developed market bonds have become less attractive
  • Renewable energy infrastructure and logistics-related real estate are among the best opportunities, along with emerging market equities

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Long Term Return Expectation (LTRE)

The macroeconomic environment changed markedly in the final quarter of 2023 as it became clearer that inflation was moving firmly towards central bank target levels. Accordingly, the narrative conveyed by central banks also changed, with the balance of risks moving more towards protecting growth. That being said, inflation is still the policy priority of most developed market central banks, hence they are maintaining interest rates at relatively high levels.

Against this improving inflation picture, the growth backdrop remained relatively stable, albeit US exceptionalism offset weaker growth in Europe and China. But this overall stability in growth, alongside falling inflation, is a ‘goldilocks’ outcome akin to immaculate disinflation: central banks have succeeded in bringing down inflation without forcing a recession. This has been a boon to asset markets, with bond and equity markets performing strongly into year-end.

However, the journey is not complete. Much of the reason behind the recent fall in inflation has been the reversal of the supply chain disruptions caused by the increase in demand for goods during the pandemic. However, the robustness of the US labour market and relatively high wage inflation are still a threat to the Federal Reserve consistently achieving its inflation target of 2 per cent. This is something it will be acutely aware of when thinking about forward policy guidance.

The challenge now, therefore, is to bring down inflation in the service sector, which is more closely tied to wages than economic growth. To get to this point, financial conditions would likely have to tighten, meaning growth would slow down and asset prices would fall.

This tightrope leaves us erring on the side of caution. If growth continues to slow, we risk a rapid economic deceleration as restrictive policies stay focused on inflationary concerns. However, if policy is loosened too soon, thus allowing growth or inflation to surprise on the upside, a rapid resumption of interest rate hikes would not be inconceivable.

Putting doom and gloom to one side for a moment, while there is a relatively narrow path to follow, economic activity has so far managed to avoid wandering off a cliff. Most probably, central banks will be quietly pleased with current progress.

In summary, it is our view that inflation will continue to moderate, dropping back towards central bank targets in the short-to-medium term. We expect consumer demand to continue easing, although low unemployment rates and continued wage inflation pose the most significant risks to the contrary.

In this summary table, and at the end of the asset class outcomes section, we have rounded our forecasts to the nearest 0.25 per cent. 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 have increased our growth forecasts for most economies as artificial intelligence (AI) and industrial policy delivered a boost to productivity. Our forecasts for average inflation-adjusted growth for the US have increased to 2.2 per cent, for the Eurozone and Japan to 1.4 and 1.3 per cent respectively, and for the UK 1.8 per cent over the next 10 years. Across this cohort, we expect the labour force to stagnate due to an ageing population and lower immigration, so all the increase in growth should come from productivity. This is higher than seen in the last decade, though still below the levels experienced during the productivity surge of the 1990s.

For further insights into productivity growth, we have published two papers on our website – The Productivity Surge of the 2020s, and Productivity growth: unravelling the slowdown and forecasting a pick-up.

For emerging markets, excluding China, we forecast real growth of 3.5 per cent, also boosted by AI and industrial policy. We reduced our baseline expectation here given the change in the Chinese growth model and our view that significant economic stimulus from the government is unlikely.

We expect China’s economy to slow over the next decade but still register a respectable 3.4 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 converge 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 are aimed at curbing demand.
  • Supply shortages have eased. Some industries that saw constrained capacity, such as semiconductors and shipping, may well move into oversupply in the medium term, provided the absence of any exogenous geopolitical shock.
  • The Bank of Japan remains seemingly comfortable with highly supportive monetary and fiscal policies, further supporting higher inflation expectations.


Because of high inflation following the pandemic, we had expected central banks to follow a policy of average inflation targeting (AIT) which waits for long-term averages to exceed targets before adjusting interest rates, thus requiring below-target inflation for a time. However, because no central bank has demonstrated this approach over the last year, we have reduced our expectations of this occurring and our average 10-year forecasts have therefore increased slightly.

For example, in the US, we expect annual consumer price inflation (CPI) to fall only briefly from its current 3.4 per cent rate to below its longer-term target of 2.0 per cent, before returning to target for the rest of the decade. That produces an average 10-year inflation figure of 2.2 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
  • 1.8 per cent in Japan
  • 1.8 per cent in China
  • 3.8 per cent in emerging markets outside China

 

We recognise that this scenario may be wrong, and we remain vigilant regarding 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 believe policy rates are currently at their peak in all major markets for this economic cycle. We expect that they will begin to fall as inflationary pressure eases, because central banks do not want to tighten policy further by allowing the ‘real rate’ – the difference between interest rates and inflation – to rise further. This path should facilitate lower bond yields of longer maturities, albeit the scale of interest rate cuts matters. In thinking about their future trajectory, we place significant weight on factors such as the high levels of global savings, which will also support bond yields.

We expect the significant rise in policy rates we have just witnessed to be a relatively short-term phenomenon. We think the US policy rate has peaked at 5.4 per cent, but over the decade it should settle at its neutral level of 2.9 per cent. Our view on this neutral rate has increased 0.9 per cent, reflecting the work we have done on AI and industrial policy that has raised our growth expectations, but also our view of increased risks emanating from geopolitics, government debt levels and uncertainty over inflation.

Similarly, while more policy tightening in the Eurozone and UK is very plausible in the short term, we expect cash rates to fall from their current levels to finish the decade at 1.9 per cent and 2.7 per cent, respectively.

 

Asset class outcomes

Following the sharp reversal in yields at the end of the year, developed market bond returns are much less attractive versus cash, although they could still provide further positive and diversifying returns in a recession outcome. Given this is something we still assign a reasonable probability to, we have maintained a modest allocation to longer-dated bonds issued by Australia and Canada and, to a lesser extent, the US.

We are still positive about emerging market local currency government bonds, where we forecast a 10-year return of 2.75 per cent above cash. Central banks in the emerging world responded to the rise in inflation by raising interest rates sharply and more quickly than developed market central banks, and are now starting what we expect to be significant easing cycles over the coming years as inflation subsides.

Similarly, we think hard currency emerging market bonds (those priced in major currencies such as US dollars or euros) can perform well from elevated spreads, which we believe overstate long-run credit risk. We forecast a return of 4.25 per cent above cash.

In mainstream credit markets (investment grade and high yield), returns are lower than our last iteration. However, spreads above risk-free rates in the structured finance market reflects more default risk than will materialise. We expect this asset class to continue to deliver good long-term returns. In the case of mezzanine bonds, we project a return over cash of 5.75 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 2.50 per cent above cash will still be lower than the very long-run expected outcome of 3.25 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 of 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 4 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 6 per cent returns over cash for core infrastructure.

Risk factors

The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication was produced and approved in March 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.

All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.

The images used in this communication are for illustrative purposes only.

 

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