Asset class return forecast for the next five years

A key finding from our research is that returns from equity markets will fall victim to an unfavourable shift in the business cycle. The global economy is approaching the end of its post-Covid expansionary phase. Tighter financial conditions, a peak in US jobs growth and large output gaps all point to a recession this year or next. This has significant investment implications. There is a considerable difference between making an allocation to stocks in the lead-up to a slump and doing the same once recovery begins to take root. And that’s true even for those who invest over long time horizons.

Our analysis of the past 100 years shows that an initial investment in developed market stocks after the end of a recession delivers a price return of 10 per cent a year for the following five years; investing before a recession, as would be the case today, has by comparison typically delivered only a 4 per cent annualised return – a shortfall of some 6 per cent per year.

Another obstacle for developed equity markets is a looming squeeze on corporate profit margins. With wages and raw materials prices rising, more stringent regulations adding to the costs of doing business and the prospect of a rise in corporate taxation, margins can be expected to fall by a cumulative 10 per cent over the next five years.

But it is not only developed market stocks that will struggle to match their past performance. Developed government bonds will also labour to deliver what investors require of them over the next five years. Such securities have traditionally served as an anchor for a diversified portfolio – a crucial source of income and capital protection during periods of economic uncertainty.

Yet outside the US – where initial valuations for government and investment grade bonds are becoming more attractive thanks to this year’s spike in yields – returns from developed market fixed income will fall below inflation over the next five years.

To make up for the lacklustre returns and income on offer from the developed world, investors will have to strike a delicate balance. On the one hand, our analysis indicates that, on average, portfolios will require higher allocations to stocks and bonds from emerging markets, as well as commodities – riskier investments that offer higher prospective returns. On the other, it would be prudent to accompany this dialling up of risk with a higher allocation to assets that do not move in lockstep with mainstream stocks and bond markets, such as liquid alternatives, gold and private assets.

Within emerging markets, Chinese stocks look particularly attractive while emerging market bonds’ income-generating potential should grow, enhanced by what we believe will be a steady appreciation in developing world currencies.

Among alternatives, non-energy commodities look especially appealing; their returns should be in excess of inflation over the next half a decade.

Our analysis also shows real estate and private equity both outperforming developed market equities over our five-year forecast horizon. Allocations to gold and infrastructure, meanwhile, make sense at this juncture as a means to diversify risk and protect portfolios against the possibility of stubbornly high – or volatile – inflation.

The next five years, then, present investors with a conundrum. They can remain faithful to the traditional balanced portfolio of mainstream bonds and stocks but, in doing so, accept a lower return and potentially higher volatility. Or they can take a less familiar path and allocate more of the capital to alternative assets. Our analysis suggests, the second option is the wiser course.

Instead, we expect the equilibrium rate to be slightly higher, with considerably higher volatility of outcomes – we see it ranging between 2 per cent and 3 per cent across much of the developed world, albeit with ever more frequent spikes higher and lower.

Crucially – and unlike during the 1970s – there aren’t many signs of inflation flowing through to wage demands. Wage demands  became embedded when inflation expectations started to rise. This time around, central bankers’ record of maintaining long-term price stability has kept them in check.

As supply bottlenecks caused by Covid start to unblock and the impact on commodity prices of Russia’s invasion of Ukraine begins to fade, price pressures will dissipate. But ultimately, inflation is determined by economic policy, which means it’s a political choice and politicians seemed to have learned past lessons of high inflation. 

And the new set-up worked. The global economy experienced a golden age characterised by rapid productivity gains, surging trade volumes and the emergence of China as new economic superpower. Financial markets also benefited enormously. Equities experienced one of their longest and strongest ever bull markets; risk premia collapsed to near zero;  bond yields fell sharply as inflationary pressures dissipated. 

But all this came to an end with the Global Financial Crisis (GFC) in 2008The Rise and Fall of the Neoliberal Order, Gary Gerstle, May 2022. The GFC ushered in a period of intense soul-searching among policymakers that resulted in a steady dismantling of the Washington Consensus and the re-emergence of a more interventionist state. The watershed moment was the introduction of quantitative easing in 2008-2009 by all major central banks through which they became the first and last-resort buyers of government bonds, effectively determining the real cost of capital for investors. QE was conceived as a temporary solution to an emergency situation.

But as the emergencies multiplied, not only did QE become the default setting but national governments – spurred on by voters – also embraced tighter regulation of the economy and finance.  As a consequence, the role of financial markets – efficiently channelling capital from savings to companies to maximize return and productivity with the least disruption and volatility – is now being tested.