Core Matters: Shaving expectations - our new 5-year return forecasts

Highlights:

• Global economic resilience, solid earnings growth, cooling inflation and monetary easing have boosted risk assets since the release of our Capital Market Assumptions a year ago. Bonds have benefitted from a mild pullback in yields.
• The return outlook looks decent, if now less exciting. A more challenging starting point has led us to shave 5-year expected returns – notably for Euro Fixed Income (FI). Yields may retrace further in the coming year, but we see limited scope for capital gains to add to income over 5 years.
• International diversification pays off. Even adjusting for FX hedging costs, US FI offers higher carry and greater capital gain potential, longer term. EM external debt looks attractive, if less than last year, thanks to a resilient EM outlook amid the Fed’s easing and muted EM vulnerabilities.
• Public debt is no longer as “risk free” as it used to be, after public deficits and debt soared. Yet we expect the headwinds from mildly wider EGB spreads still to be moderately overcompensated by extra income from risk premia.
• Credit is still attractive, also within the euro area. Admittedly, spreads are already very tight. But contained default rates and solid corporate balance sheets, at least for large companies, should keep them tight: credit carry still looks appealing. US HY spreads look more vulnerable, but the expected pullback in Treasury yields and the higher income offer protection.
• Equities should render mid-digit returns, leading the ranking. But the expected margin vs. EM and Credit FI is small while entailing much higher risk exposure. Despite the rally and high valuations, US equities are buffeted by strong US earnings prospects. Mind, however, FX hedging costs and concentration risks linked to S&P500 exposure.
• Risks abound. Equity volatility may enter a higher regime (valuation, concentration, geopolitics). Rates volatility will restart its descent, but elevated inflation uncertainty (both sides now) means it will not return to the pre-Covid lows. Among the many risks, we highlight three. First, yields may stay high for longer on stagflationary shocks (e.g. escalation in Middle East, global trade war). Second, political uncertainties and polarisation may fuel debt sustainability worries and a rise in fiscal risk premia. Third, in a Goldilocks scenario, inflation may come down much more swiftly while AI adoption boosts productivity and supply side growth faster and more strongly.

1. Introduction 

What a difference a year makes. A year ago when this annual report was released “The power of yield” it looked like 2023 would be mediocre for liquid assets, following an awful 2022. 4Q23 then rescued the year, as stocks and bonds rallied in sync. 

After nearly 10 months, 2024 looks good overall, if more contrasted – mediocre for bonds and excellent for equities. The two upper-right charts summarise how the phenomenal equity rally over the past year has propelled a typical 60-40 stock-bond portfolio. Last year we talked about a lost decade for bonds, and 2024 has not marked the end of this era: 10- year Treasury and Bund yields have lost some 50-75bp over the past 12 months, supporting small capital gains there, but those were heavily concentrated in 4Q23. A lost decade in bonds. The chart below shows that both the Treasury and Bund indices have delivered negative nominal returns over the past 10 years, as the rise in yields has generated capital losses, particularly since the trough reached in 2020 (pandemic). 

In contrast the last decade has been strong for equities, with the MSCI World (developed markets) delivering more than 10% annual nominal returns. At that pace, portfolio value doubles in just over 7 years. The equity performance has been driven by the US, at nearly 12% p.a. This is strong, yet very much in line with US standards. Over the past century, the S&P500 10-year average nominal return (p.a.) stands at 11%, with the distribution going from - 3% to +22%