Capital Market Assumptions: A Comprehensive Global Approach for the Next 20 Years
Asset returns in general over the next 20 years are expected to be lower than long-term averages, with stocks likely to outperform bonds and emerging markets likely to boast the highest returns.
- Our long-term capital market assumption for U.S. equities is below long-term average returns due to lower growth potential and higher starting valuations.
- Emerging-markets stocks represent the most attractive area for public market return expectations due to favorable growth prospects and better starting valuations.
- Fixed income return expectations are higher compared with 2021 due to higher starting bond yields.
- Higher-than-expected inflation likely would hurt most equity and fixed income returns, with long-duration nominal fixed income facing the most risk from higher inflation.
- One scenario that could boost equity returns is continued central bank induced financial repression, which could keep real rates low and support higher valuations relative to historical averages.
Expectations based on our 2022 capital market assumptions
- For U.S. stocks, we expect a 3% annualized real return through 2042, less than half the 6.6% average since 2001 and the 7.1% advance since 1926. Our 20-year real return estimate declined from 3.1% in 2021. Risk-adjusted return estimates remain lower than their historical norms.
- Valuations for U.S. stocks remain elevated compared with the rest of the world. We believe they will converge closer to those of other developed markets over time.
- Compared with 2021 we see reduced earnings potential for U.S. stocks as higher rates increase corporate interest expenses. Offsetting this negative, we note that the decline for the U.S. stock market in the early half of 2022 resulted in more-attractive starting valuations.
- We expect bond markets to produce a real return of 1.9% annualized over the next 20 years, vs. 2.1% a year historically (since 1926). This estimate rose from 1.5% in 2021, largely influenced by higher yields that increased the attractiveness of new bond investments.
- One meaningful risk is that higher-than-expected inflation over the next two decades could reduce the returns of long-duration nominal fixed-income assets, such as 30-year Treasury bonds.
- Partly reflecting increased interest rate and inflation risks, we expect bonds to produce a lower Sharpe ratio relative to the past two decades.
- Emerging equities represent the most promising area in the public markets, due to our expectations for higher real GDP growth and low starting valuations.
- We anticipate a 5.1% real return for emerging markets in the next 20 years, compared with a 6.1% real return over the past two decades.
Developed Markets (ex-U.S.)
- We expect most non-U.S developed countries, including Australia, Canada, the UK, France, Germany, and Japan, to lag the real GDP growth of the U.S. through 2042, mainly due to birth rates and other demographic trends. This is expected to keep earnings growth subdued relative to the U.S. and emerging markets.
- Return estimates for developed-equity markets outside the U.S. are 3.3% in real terms over the next 20 years, topping U.S. stocks. We expect a diminished return for developed non-U.S. markets versus the long-term historical average, and slightly higher volatility compared with the U.S., based on a higher concentration of more-cyclical sectors.
U.S. Bonds vs. U.S. Stocks
- We expect the lower return environment will result in less attractive risk-adjusted returns for global equities compared with the historical average, with Sharpe ratios remaining relatively even across core stock and bond categories (Exhibit 2 in PDF).
- Our forecasts place the 1.1% expected gap between the real returns of U.S. equities and U.S. investment-grade bonds over the next 20 years in the 7th percentile relative to history, which is significantly lower than the previous two decades (Exhibit 3).
- A higher rate of inflation could increase this performance gap going forward and coincide with higher correlations between stocks and bonds.
EXHIBIT 3: Over the next 20 years, we expect U.S. equities to outperform bonds by a smaller margin than they did during the past 20 years.
Source: Investments (AART), as of 4/30/22.