Twice a year, we conduct an extensive update of our five-year return forecasts. The purpose of this exercise is two-fold. First, taking a longer term perspective helps set strategic asset allocations and design portfolios for diverse investment goals. Second, and equally important, maintaining long-term forecasts provides helpful context for responding thoughtfully to daily swings in market prices.
How we arrive at our capital market assumptions
For this update, we began with a complete overhaul of our economic and interest rate forecasts following the election of President Trump. The new administration intends to bring a comprehensive shift to the conduct of economic policy, and the changes we expect, including tax cuts, deregulation and fiscal stimulus, will create a new and higher trajectory for both economic growth and inflation. The sum of real economic growth and inflation equals nominal economic growth. Our central case focuses on the capital market implications of this positive inflection for nominal economic growth as a worldwide phenomenon. A higher trajectory for nominal economic growth should in turn bring about a normalization of monetary policy. Because our central case may not come to pass as we describe, we must also consider alternative scenarios for robustness’ sake.
Our central case and two alternative scenarios
Our central case presumes a departure from the “secular stagnation” conditions that have dominated financial headlines for many years. We identified two important deviations from our central case that helped to define alternative scenarios. Our alternative scenarios contemplate a world where policy changes are in one case ineffective, and in the other actually counterproductive. As such, we find ourselves in the peculiar circumstance that the central case represents the best case scenario for investors.
Most likely: In our central case scenario, we expect to see a positive inflection for global growth in nominal terms. Such a shift ought to be, in our estimate, positive for equity markets but challenging for bond markets. Certainly, this view is compatible with the market reactions that we have observed over the past several quarters. Our central case contemplates more of the same, with a key feature being that both of these trends expand globally, with valuation more supportive for equities and more stretched for bond yields. In this scenario, we expect policy rates to normalize and for inflation-sensitive assets to perform reasonably well.
Less likely: Alternative scenario one, the policy ineffectiveness scenario, considers the possibility that economic policy reform is not able to overcome the forces of deflation. In this scenario, we would find ourselves in the familiar territory of low growth, low inflation and ample policy support. In this scenario, a recession is probable within a five-year forecast horizon.
Least likely: Alternative scenario two, the global backlash scenario, considers the consequences of realized policy changes resulting in isolationism and protectionism, stunting global trade and bringing about a sequence of responses that serve to increase geopolitical tensions around the globe. In this scenario, a recession is a near certainty and financial markets would perform poorly. We view this as a low probability scenario at the moment, but we remain attentive to any indication that the likelihood of this path is rising.
Our final forecasts represent a weighted average of expected asset class performance across all three scenarios. The chart below shows the weighted average expected annual returns produced by this framework, along with the levels of expected return at the time of our last update in July 2016.
Observations and key takeaways
Expected returns, in nominal terms, have risen since the mid-year 2016 forecast.
Even so, expected returns remain below historical averages for all major asset classes.
Equities retain an expected return advantage over bonds, broadly speaking, and that advantage has increased.
The highest expected returns, not surprisingly, correspond with the highest economic growth sensitivity.
Higher expected returns from equities result from an improvement in corporate earnings, which likely ensues from a higher growth environment.
Higher expected returns from bonds result from higher yields and better coupon reinvestment opportunities over the next five years.
A sensitivity analysis of the three scenarios offers additional insights:
Equities are expensive; in the event that our downside scenario materializes, the expected drawdown from equity investments could be severe.
Bond returns are not as negatively skewed across our scenarios. The improved reinvestment return matters a great deal to our five-year return forecast.
While we do not explicitly forecast sector returns or factor efficacy, in either the first or third scenario we would expect far more pronounced winners and losers and therefore falling asset class and security level correlations. In those scenarios, active investment strategies might find more success than has been the case in recent years.
Bottom line