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2023 Long-Term Capital Market Assumptions

Mon 05 Jun 2023

Back to Basics

Lower valuations and higher yields mean that asset markets today offer the best long-term returns in more than a decade. It took a painful slump in stock and bond markets to get here, and the worst may not yet be over.

But after a year of turmoil, the core principles of investing still hold firm. Once again, 60/40 can form the bedrock of portfolios, while alternatives can offer alpha, inflation protection and diversification. Meanwhile, the end of free money, greater two-way risk in inflation and policy, and increased return dispersion across assets also give active managers more to swing for.

In the near term, investors face a challenging time as a recession, or at least several quarters of subtrend growth, lie immediately ahead. Still, our assessment of long-term trend growth is only marginally below last year’s. We expect today’s inflationary surge to eventually subside to a rate only slightly above our previous estimates.

Bonds normalize, stock forecasts soar

Our forecast annual return for a USD 60/40 stock-bond portfolio over the next 10–15 years leaps from 4.30% last year to 7.20%.

After policy rates normalized swiftly, bonds no longer look like serial losers. Once again, they offer a plausible source of income as well as diversification. Higher riskless rates also translate to improved credit return forecasts.

Projected equity returns rise sharply. In local currency terms, our developed market equity forecast rises 340 basis points (bps), to 7.80%, and in emerging markets jumps 230 bps, to 8.90%. Corporate profit margins will likely recede from today’s levels, but not revert completely to their long-term average.

Stock and bond valuations present an attractive entry point. Alternatives still offer benefits (diversification, risk reduction) not easily found elsewhere. With the U.S. dollar more overvalued than at any time since the 1980s, the FX translation will be a significant component of forecast returns.

Scarce capital, surging demand for capex

Many long-term themes affecting our outlook (demographics, shifts in globalization patterns) will demand higher capital investment – paradoxically just as the abundance of cheap capital of the last decade is reversing. As financial markets look to efficiently allocate scarce capital, the result may be more idiosyncratic returns, and lower correlations within indices.

Overall, the return outlook in this year’s Long-Term Capital Market Assumptions stands in stark contrast to last year’s. Headwinds from low yields and high valuations have dissipated or even reversed, and asset return forecasts might be considered “back at par”.

Asset reset, attractive entry point

It has taken a meaningful reset in asset markets to bring us to this place, and considerable pain for bondholders over a much shorter horizon than we had expected. Still, the underlying patterns of economic growth look stable, and the assumptions that underpin asset returns – cycle-neutral real cash rates, curve shape, default and recovery rates, and margin expectations – are little altered.

But the market drawdown in 2022 is now creating an increasingly attractive entry point for long-term investors. While 2022 was a painful ride as long-standing dislocations closed sharply, investors can now look forward to compounding future returns at much more attractive levels.

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