Released August 2020
Every year, Northern Trust’s Capital Market Assumptions Working Group develops forward-looking, historically aware forecasts for global economic activity and financial market returns that drive our five-year asset class return expectations and inform our asset allocation decisions.
All of this comes together in the form of our long-term strategic asset allocations, which are used by institutional and individual investors worldwide.
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In recent years, global equities had slightly outpaced market forecasts for lower equity returns. Then the COVID-19 pandemic hit the global economy, putting an end to the 10-year bull market. Equity markets have now started to recover, but the pandemic introduced and exacerbated challenges that we expect to subdue financial market returns over the next five years. Here are the six themes shaping our outlook:
- RETOOLING GLOBAL GROWTH — Companies will prioritize stability over profitability by re-routing their supply chains, moving production inside their home countries, and building healthier balance sheets. After the stimulus-induced surge, global growth will settle at low levels.
- MASSIVE MONETARY TOOLKIT — The controversial Modern Monetary Theory (MMT) — which advocates for greater coordination between monetary and fiscal policy — is, in reality, already being applied. This evolution has given central banks (recently viewed as ineffective) a big new toolkit.
- STUCKFLATION TESTED — Inflation faces a test from many of this year’s themes — notably Retooling Global Growth; One World, Two Systems and Massive Monetary Toolkit — but the effects of slow growth, technology and automation will keep inflation at or below central bank targets.
- ONE WORLD, TWO SYSTEMS — Last year’s Irreconcilable Differences theme is evolving to where the U.S. and China will learn to live on the same planet with their opposing views on economic policy. Collaboration won’t be absent, but won’t be optimal either — leading to inefficiencies.
- REIMAGINING CAPITALISM — For everyone to believe in (some form of) capitalism, rules alleviating the “winner take all” dynamic must evolve. Business leaders, the ultra-wealthy and politicians representing those left behind will find a way to forge a new capitalism that works better for all.
- STAY FOCUSED ON CLIMATE RISK — The pandemic took focus off climate-related issues, but the risks have not gone away. In some cases, they have intensified. Post-pandemic economic rebuilding will force leaders to re-engage with climate risk — a headwind for some industries but a tailwind for others.
2021 ASSET CLASS OUTLOOK
This year’s broad themes identify the trends we see affecting the markets and economy over the next five years — and they also underlie our asset class outlooks.
We expect economic actors will be Retooling Global Growth as they deal with the pandemic fallout amid calls for more resilient business and economic models. Tensions between the U.S. and China will remain high, leading to a less efficient One World, Two Systems global dynamic. That, combined with central banks’ Massive Monetary Toolkit, will lead to Stuckflation Tested. Reimagining Capitalism and a call to Stay Focused on Climate Risk round out the key themes we expect to impact financial markets over the next five years.
EQUITIES – A mix of elevated valuations, slow global growth, lower profit margins and broader focus on stakeholders versus just shareholders will subdue returns. Emerging markets, carrying attractive valuations but also much uncertainty, will slightly outpace developed markets.
FIXED INCOME – Low but steady interest rates should translate into low but positive returns over the next five years. High yield stands out as an alternative to global equities with its higher yields, higher expected total returns and lower risk profile.
REAL ASSETS – The possible permanent impairment of retail and office properties will hurt global real estate, while natural resources will struggle through subdued global demand. Listed infrastructure will stand out as a higher-yield, lower-risk asset class in a higher risk world.
ALTERNATIVES – Private investments are providing attractive premiums to public market counterparts. But the “average” hedge fund has struggled to provide meaningful alpha. The range of outcomes across alternative strategies will remain wide, making manager selection paramount.
EQUITIES
OUTLOOK: MID-SINGLE-DIGIT RETURNS
A mix of elevated valuations, slow global growth, lower profit margins and broader focus on stakeholders versus just shareholders will subdue returns. Emerging markets, carrying attractive valuations but also much uncertainty, will slightly outpace developed markets.
Global Equities
We have lowered our five-year annualized global equity return forecast to 4.9%. This 0.9% reduction is driven by our U.S. forecast, in which we believe U.S. market valuations are elevated beyond what should be expected, even in the current low-rate environment.
Developed Markets
Developed market equity returns should range from 3.8% (Japan) to 5.8%
(Australia) – all below historical averages and the 6.2% forecasted by our quantitative model.
Emerging Markets
Our expectation of 5.4% for emerging market equity returns, driven primarily by China and Asia, is a mere 0.6% return premium to developed markets.
FIXED INCOME
OUTLOOK: LOWER FOR LONGER (AGAIN)
Low but steady interest rates should translate into low but positive returns over the next five years. High yield stands out as an alternative to global equities with its higher yields, higher expected total returns and lower risk profile.
Interest Rates
Slower growth and central bank desire for (but not a realization of) higher inflation will keep short-end rates at zero or below. As short-end rates stay low and inflationary problems do not materialize, we expect longer-end rates to fall short of five-year market expectations.
Investment-Grade Credit
Despite low interest rates, yield curves are actually fairly steep. This implies returns can outpace starting point yields, especially given our view that interest rates will stay below market consensus, resulting in price gains.
High-Yield Credit
We expect a 5.6% global high yield annual return as lower interest rates drive the ongoing search for yield and support asset class fundamentals.
REAL ASSETS
OUTLOOK: HEADWINDS AHEAD
The possible permanent impairment of retail and office properties will hurt global real estate, while natural resources will struggle through subdued global demand. Listed infrastructure will stand out as a higher-yield, lower-risk asset class in a higher risk world.
Natural Resources
Our forecast for natural resources saw a material reduction of 1.5%, resulting in a 3.6% annual return forecast. This is driven by our outlook for slow growth and the extra scrutiny of the environmental impact of natural resource companies.
Global Real Estate
Our 6.3% forecast for global real estate reflects a 2% qualitative reduction. While term and credit risk exposures should be supportive, they will likely be offset by permanent impairment of many property types, notably retail and office spaces.
Global Listed Infrastructure
In contrast, global listed infrastructure’s term exposure, yields and historical downside protection should make it attractive in our expected economic and market environment, keeping our forecast steady at 5.8%.
ALTERNATIVES
OUTLOOK: MANAGER SELECTION PARAMOUNT
Private investments are providing attractive premiums to public market counterparts. But the “average” hedge fund has struggled to provide meaningful alpha. The range of outcomes across alternative strategies will remain wide, making manager selection paramount.
Private Investments
We expect private equity to generate a 3.0% premium over global equities, bringing our forecast to 7.9%. This represents an impressive alpha/illiquidity premium even after correcting for the lagged appraisals of private equity assets.
Hedge Funds
Hedge fund beta has been fairly steady over the past 10 years, but the alpha contribution of the asset class has been in notable decline. Our 2.6% hedge fund return forecast represents the combination of expected alpha (0.4%) and expected returns from risk exposure (2.2%).
Given the wide range of strategies and resulting performance dispersion, a focus on manager selection is extremely important — and can make the difference between buying expensive beta and gaining true alpha.
© Northern Trust
© Northern Trust
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