Capital Market Assumptions: Expectations for the next 10 years in a new regime

Capital Market Assumptions: Expectations for the next 10 years in a new regime

Jeffrey Palma

Head of Multi-Asset Solutions

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John Muth

Macro Strategist

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16 minute read

June 2023

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Our Capital Market Assumptions reflect that we are in the early stages of a significant and far-reaching macroeconomic regime change.

KEY TAKEAWAYS

  • Our Capital Market Assumptions reflect higher yields relative to the previous 10 years, stubbornly higher inflation, slower real growth, and higher volatility.
  • Fixed income, driven by the higher current starting point of yields, is expected to have significantly higher annualized returns than the prior 10 years, while U.S. equity returns are expected to be lower facing slower growth and a higher cost of capital as well as higher risk premia.
  • We believe real assets are well positioned for stronger annualized returns over the next 10 years amid a more inflationary environment, supportive valuations, and a period of undersupply.

Our Capital Market Assumptions for the next 10 years reflect that we are in the early stages of a significant and far-reaching macroeconomic regime change that was set in motion over the past three years.

A mismatch between high demand (driven by monetary stimulus) and impaired supply in the wake of the pandemic and the war in Ukraine, on top of longer-term demographic, geopolitical and economic shifts caused inflation to spike. The Federal Reserve and other central banks responded by raising interest rates and moving from quantitative easing to quantitative tightening.

While we are past peak inflation, we believe the risks of bouts of inflationary shocks over the next decade have increased. In our view, this new period will be marked by labor scarcity, commodity underinvestment, increased geopolitical uncertainty, and a move away from globalization and toward “friend-shoring” (i.e., trade partner selectivity).

Stubbornly higher inflation will likely result (Exhibit 1, page 3). We also factor in higher interest rates and lower real economic growth than in the last cycle in U.S. and global economies. We believe greater volatility of macroeconomic factors and the global business cycle will also lead to more frequent cycles of slowdown and expansion versus what investors became accustomed to in the prior 35 years. In turn, this drives several notable aspects of our 10-year assumptions that differ from the prior decade, including higher yields, generally lower multiples and higher premiums for risk assets.

Key differences from the prior 10 years include:

  MacroeconomicsWe expect real gross domestic product (GDP) growth in the United States to slow to 1.6% annually and global GDP growth to average 3.1% annually. We also forecast more volatility (particularly in macroeconomic factors) as the world moves away from peak globalization, relative geopolitical stability, quantitative easing and central bank accommodation.
Fixed incomeFixed income, driven by the higher current starting point of yields, is expected to have significantly greater annualized returns than in the prior 10 years. U.S. Treasuries are a good example, having returned just 0.7% annualized in the past 10 years. Our assumptions indicate an expected annual return of 3.9% over the next 10 years.
U.S. equitiesU.S. equity returns are expected to be lower amid slower growth, lower profit margins (given higher operating expenses) and a higher cost of capital, as well as higher risk premia. We forecast improved returns for international equities due to faster growth potential and more attractive valuations today.
Real assetsWe believe real assets—in particular, natural resource equities and infrastructure—are well positioned in a more inflationary environment, driven by higher levels of profitability and a more supportive valuation backdrop. Commodities, we believe, will see a substantial improvement in returns in a period of undersupply and higher production costs. We expect average private core real estate returns to moderate.
EXHIBIT 1
Inflation expected to stay above pre-pandemic trend
Inflation expected to stay above pre-pandemic trend
Our Capital Market Assumptions for the next 10 years reflect that we are in the early stages of a significant and far-reaching macroeconomic regime change.

In the sections below, we detail assumptions for the expected returns of the various asset classes we analyze.

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A closer look at fixed income

We expect fixed income returns to be higher over the next 10 years (Exhibit 2), and this assumption centers on the higher starting point for yields that exist today.

As inflation has risen, the Federal Reserve has engaged in one of its most aggressive rate-hiking cycles ever, which raises forward-return prospects across the fixed income universe.

Our expectation is that inflation will settle out around 3%, driven by prevailing supply-side shortages in goods, commodities, housing and labor. The Fed will have difficulty achieving its old, and likely outdated, 2% inflation target on a sustained basis.

As such, we don’t expect the return to normalization that the general market anticipates.

3.9% Expected 10-year annualized returns for U.S. Treasuries
EXHIBIT 2
Higher yields driving improved expectations for fixed income

Expected annual returns vs. prior-decade annual returns

Higher yields driving improved expectations for fixed income

A closer look at equities

While yields are a rising tide that we expect to lift fixed income returns across the board, our expectations for equities are more subdued.

During the prior decade, earnings grew strongly, profit margins expanded, and multiples climbed. However, quantitative easing and accommodative monetary policy are gone, while growth is slowing. Slowing labor force growth will hold back economic growth, absent a strong revival in productivity. One development we are watching that could influence productivity is artificial intelligence (AI), with some observers estimating that productivity gains in AI could offset the expected decline in the labor force.

Our 10-year expectation for U.S. real GDP growth is 1.6%, down 0.5 percentage points from the prior decade. Global GDP growth is also expected to be lower than the prior decade at 3.1%, down 0.6 percentage points from the pre- pandemic trend. The primary driver of slowing U.S. and global real GDP growth is a decline in working-age population growth.

As growth slows, costs are rising amid higher inflation. Notably, the labor share of income is climbing higher after a multi-decade trend lower, and companies are seeing lower net profit margins. A higher cost of capital is also likely to act as a restraint on profitability and earnings growth.

At the same time, a higher required risk premium will also likely drive down equity multiples. In other words, higher rates mean that investors can achieve higher yields with lower risk in fixed income, making risk assets, notably equities, relatively less attractive.

That’s particularly true for U.S. equities, where our assumption is for annualized returns of 7.3% over the next 10 years. These returns are only slightly above our assumption for emerging markets (7.2%) and are lower than that for developed international markets (7.7%); in these markets, valuations are relatively lower now and don’t need to adjust down, unlike valuations in

U.S. equities. Expected returns stand in stark contrast to the prior decade, when U.S. equities outperformed emerging and developed international markets substantially (Exhibit 3).

7.3% Expected 10-year annualized returns for U.S. equities
EXHIBIT 3
Expected U.S. equity returns no longer exceptional
Expected U.S. equity returns no longer exceptional

Implications for real assets

The new market regime is driving higher expected returns for real assets (Exhibit 4).

Higher production costs, increased regulation, a scarcity of resources, and recent underinvestment will drive returns in natural resource equities and commodities over the next 10 years. At the same time, resource producers have faced revenue pressures for years and have instilled greater supply-side discipline and a greater focus on profitability. Better growth and higher profitability also support valuations of resource equities.

Higher expected returns for commodities, as measured by the Bloomberg Commodity Index, are also driven by higher production and extraction costs, which are the result of inflation, as well as by a longer-term shift as we move from a period of oversupply to one of undersupply. Higher expected collateral returns (in light of higher expected interest rates) will also contribute to commodity total returns.

We also expect infrastructure to perform well given predictable cash flows and the fact that many infrastructure subsectors—such as airports, marine ports, midstream energy, toll roads and towers—have revenues that adjust with inflation.

Indeed, infrastructure has historically produced above-average returns when inflation has been high but moderating. We also expect investor demand for infrastructure to remain high, as the asset class generally has lower volatility than the broader stock market due to its relative earnings stability.

In the expected higher-inflation/lower-growth environment, we believe that REIT cash flows will remain resilient and that constrained new supply will benefit real estate prices (though lower economic growth could be a modest headwind). We expect U.S. REIT returns to improve over the prior decade (8.2% vs. 6.9% annualized returns), while global REITs, benefiting from more attractive valuations in international markets, are expected to improve more sharply (8.0% vs. 3.8% annualized returns).

Listed and private real estate returns tend to be similar over long periods, but private real estate typically lags listed real estate due to its slower-moving price discovery and transactions. Listed real estate had sharp declines in 2022, while private real estate had only modest declines. We expect average private core real estate (7.0% vs. 9.7% annualized returns) to trail listed markets as this gap closes.

EXHIBIT 4
New regime portends stronger real assets returns

Expected annual returns vs. prior-decade annual returns

New regime portends stronger real assets returns

Full 10-Year Capital Market Assumptions detail

Expected annual returns vs. prior-decade annual returns
Expected annual returns vs. prior-decade annual returns
Expected asset class correlations in detail
Expected asset class correlations in detail
ABOUT THE AUTHORS
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Jeffrey Palma, Senior Vice President, is Head of Multi-Asset Solutions, responsible for leading the firm’s asset allocation strategy and macroeconomic research.

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John Muth, Vice President, is the firm’s Macro Strategist responsible for providing global macro analysis and forecasts to Cohen & Steers’ investment committees.

FURTHER READING

Secular drivers of inflation

Secular drivers of inflation

January 2024 | 4 mins

Recent data indicates a slowing inflation trend, yet risks persist. Secular forces suggest that a prolonged elevated inflation period is underway with the potential for periodic price spikes. Factors driving long-term inflation include commodity underinvestment, tight labor markets, geopolitics, deglobalization and fiscal uncertainty. We see parallels to past inflationary eras, which highlight the difficulty of controlling inflation. While not predicting a return to 9%, the expectation is for a decade of higher-than-accustomed inflation, underscoring the importance of having a real assets allocation.

Opportunities in the era of scarcity

December 2023 | 25 mins

The world is transitioning from an era of commodity abundance to one of undersupply. We believe this shift may result in significant returns for commodities and resource producers over the next decade.

The Israel–Hamas war and the implications for real assets

The Israel–Hamas war and the implications for real assets

October 2023 | 7 mins

Cohen & Steers is closely monitoring developments in the Middle East following the horrific terrorist attack on Israel. We offer a concise examination of the potential impact on real assets and the macroeconomic environment.

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