Bold forecasts that miss the mark are often quickly forgotten or swept under the rug by misfiring prognosticators.

Two years ago, we heard forecasts of “a 30–40 per cent decline in the U.S. dollar.” But as everyone now knows, the drop in the dollar didn’t happen. Compared to other developed countries’ currencies, such as the Japanese yen, the dollar is up more than 30 per cent since 2022. Further, since 2011, the dollar is up almost 40 per cent compared to a broad basket of currencies!

So why were the dollar bears so wrong? Popular misconceptions about the dollar’s role in the global financial system mislead investors and policymakers alike. These misconceptions never seem to die. We detail our favorite mistakes so that, hopefully, you won’t repeat them.

The result of human action not design

For much of its early history, the United States had nothing like a universal currency The US followed a bimetallic standard (linked to gold and silver), and paper money was shunned. However, the Panic of 1907 prompted Congress to create the Federal Reserve (Fed).

The Fed later issued “Federal Reserve notes,” lent to banks when liquidity dried up, and enforced “par” settlements for checks across the Federal Reserve System.

Then came a series of crises and some luck. The US’s favourable geographic location during the First and Second World Wars (far removed from most battlefields) allowed it to become the “centre of the global financial system.”Owning about 40 per cent of global gold reserves allowed the US to be one of the only countries that did not suspend convertibility throughout the wars.

But wasn’t the dollar system designed by policymakers at Bretton Woods after the Second World War? In reality, delegates ruled out competing plans as infeasible. In short, the dollar was just the best and easiest option.

In addition, the dollar’s reign had already gone global. The Euro-dollar market was born in the 1920s and was revived in the 1950s because London banks started accepting dollar (and other currencies) deposits and making dollar loans to third parties.

Modern-day crises have only further cemented the dollar’s global reign. During the global financial crisis, the Fed lent USD10 trillion in raw swap amounts to its major foreign counterparties, and again during Covid-19—a sign of just how vital the dollar is to the global economy.

The dollar will soon be displaced by a rival

The dollar is the most dominant currency, and its status has waned little in recent decades. According to the international currency index constructed by the Fed, the dollar has remained a steady leader in forex reserves, transaction volume, foreign currency debt issuance, and international banking claims for as long as data is available.

As for second place? It’s not even close. The Euro scores 23 on the index, one-third of the US level, though greater than the sum of the next three currencies combined – Japanese yen (JPY), British pounds (GBP), and Chinese renminbi (RMB).

Further, in 2015 countries with currencies anchored to the dollar (not counting the United States) accounted for 50 per cent of world GDP. In contrast, euro-linked economies accounted for just 5 per cent (not counting the euro area).

The world is de-dollarising.

The latest dollar bear fad is “de-dollarisation.” The argument is that major economies will prefer to use other currencies to avoid the ire of US policymakers keen to “weaponise” the dollar using sanctions.

De-dollarisation is catchy and alliterative. But it’s also wrong.

First sanctions are common and have been used for a long time. As early as 1935, the US-led League of Nations (predecessor to the United Nations) sanctioned Italy for its invasion of Ethiopia, banning loans and military equipment. In modern times, for military purposes, the US has frozen assets tied to the governments of Libya (2011), Iran (2012), Venezuela (2019), and most recently, Russia (2022).

Second, the benefits of “dollarisation” far outweigh the perceived risk reduction from de-dollarisation. Using the dollar allows you to reach 80 per cent of the buyers and sellers in global trade activity and the deepest and most liquid financial markets in the world.

While instituting sanctions dissuades some countries from holding Treasuries as reserves, it’s unlikely the bulk of dollar reserve holders will dump the dollar. In fact, overseas governments with military ties to the US own nearly three-quarters of the total US debt held by foreign governments.

In short, the benefits of operating in dollars far outweigh the costs of de-dollarisation.

Debt overhang will sink the Dollar

Another common misconception is that the dollar is (always) on the brink of collapse due to excessive debt burden. Headlines often tout the “USD27 trillion in marketable debt outstanding.”

From a first approximation, we find this view tedious. For the last 30 years, one could have said the same thing every day of every month in every quarter of every year. So far, the predictive value is nil, for the cumulation of national debt has yet to lead to higher yields or a debt default.

The debt issue is overstated. The average cost (yield) of US debt is only 3.4 per cent as of July 2024, still much lower than most of the country’s recent history, thanks to the dollar’s status as the global reserve currency and decades of price stability since the 1990s. Unless the Fed funds rate stays above 5 per cent for a few more years, we’d argue that the current trajectory of the US debt burden remains manageable.

 Dollar doubters beware

Contrary to popular belief, there are no viable rivals to the dollar. De-dollarisation may occur to a limited extent and be led by bad actors in the global financial system. Still, users of the dollar system overwhelmingly benefit from trading, borrowing, and saving in dollars. Further, debt burdens do not yet threaten the dollar system’s stability, with debt service costs manageable and dollar debt buyers more eager than ever to hold greenbacks.

There’s a lot of demand that’s supporting the market. We think government bond yields have the potential to be volatile this year and will dictate the total returns for fixed income broadly. 

However, global high yield is a lower duration asset class and will be less impacted by what happens with government bond yields and more impacted by credit quality and how strong the economy is. These things are positive for the market. 

Global Economy

We expect strong growth in 2024, especially in the US because business activity is picking up and is being supported by a strong labor market. The expectation is that central banks, especially the Fed, will start to ease monetary conditions, which will be another tailwind for the economy in 2024.  

Outside the US, it’s less clear, but should be positive, just not as robust as the US.  There are areas globally like China that are slowing down and Chinese activity has ripple effects through other parts of the global economy, especially Europe. But we still expect there to be growth. 

Rate expectations

We expect to see the Fed cut rates at some point in 2024. The question is when and how many get pushed into 2025? We did have hotter-than-expected inflation data early this year that has pushed some into thinking the Fed will hold out and move later than originally expected. We think that some of the early year inflation numbers showed higher readings because of seasonal factors more than showing a change in trend. Once that trend resumes and shows a downward trajectory for inflation, the Fed will begin cutting rates because rates right now are restrictive and they know it. 

In Europe, the markets are pricing in a similar number of rate cuts by the European Central Bank (ECB) and the Bank of England to the US. If we were to bet on a market that’s more likely to cut first, we would say it’s over here in Europe.

For example, growth is more lackluster here. But also, especially in the UK, higher interest rates feed more quickly into the economy because mortgage terms are mostly shorter than five years. We think the Bank of England is wary of that, and that it’s a matter of time before the force of all the rate hikes of the last few years starts to weigh more heavily on the consumer.

A good environment 

For global high yield, we saw close to 13 per cent return for 2023. 2024 is going to be harder because the potential for capital appreciation is limited. That leaves the carry component and the coupon as the main driver of returns. We think it’s going to be a supportive environment for investors to capture that carry and will result in a 7 per cent to 8 per cent type of return for global high yield, which is very good.

Furthermore, default expectations remain low. Expectations are about 2 per cent in Europe and closer to 3 per cent in the US, but also, recovery rates have been robust. 

At this point from a valuation perspective it’s much more about being issuer specific than sector specific for us. We’ve also been finding value in other high-yielding markets: some high yield emerging market sovereign debt and some BBB CLO exposure, though not overriding the main thesis of the strategy which is high yield corporates. 

New issuance should be higher this year. Last year in the European market, we had just under USD50 billion in new issues. The US market was just under USD200 billion. We think that number has upside potential given the refinancing needs, due to the maturity walls that we have in 2025. The high yield market likes to refinance at least a year in advance.  Investors like to see that issuers can term out their upcoming maturities a bit earlier than in other markets which that creates more investment opportunities.

Investment Grade vs High Yield

One of the things that high yield has over investment grade is it’s not as sensitive to interest rates. Interest rates are such a big driver of volatility in the fixed income market currently. That’s something that tends to weigh more on investment grade returns than it does high yield.

If your biggest fear this year is that inflation could pick up and weigh heavily on fixed income markets, that’s really going to be a government yield issue. And given the fact that high yield is a three-year duration versus investment grade at an eight-year duration, a 100 basis point increase in rates is only going to cause the high yield market to sell off 3 per cent and the coupon of 7 ½ per cent will more than make up for that. Whereas investment grade would sell off by 8 per cent and the coupon is 4 per cent or 5 per cent. That’s not going to make up for that move, so there’s a better buffer with high yield.

Cerulli’s finds while just 14 per cent of asset owners have a formal net-zero commitment, another 25 per cent plan to make one in the next 12 months. In addition to institutions making broad commitments to net-zero goals, Cerulli data reveals that many are taking other actions related to carbon, sometimes overlapping or tangential to the net-zero goal. Nearly one-third (30 per cent) of institutions are investing in strategies that support transition to a carbon-neutral economy, and another 36 per cent plan to over the next 12 months. 

Additionally, half of institutions are either divesting (29 per cent) or plan to divest (21 per cent) from fossil fuels. When undertaking responsible investment strategies, institutions continue to prioritise addressing the issue of climate change (61 per cent) as the top theme.

Despite these efforts, investors continue to face difficulties analysing and reporting on the carbon footprint of their underlying investment portfolios. The lack of data standardisation across third parties and publicly available tools makes it challenging for investors to get a clear picture of exposure and ensure alignment with their climate change commitments.

New platforms, including the Net-Zero Data Public Utility (NZDPU) database, are expected to come to market to establish more reliable, accessible, and comparable climate data across various industries for investors. “The development of such platforms will provide investors with more complete information about their exposure to climate-related financial risk,” says Gloria Pais, analyst. “Looking ahead, Cerulli anticipates an increase in industry partnerships with current disclosure platforms to enhance consistency and provide managers, investors, and other industry professionals with the data they need.”

In calendar-year 2023, 44 per cent of Morningstar’s sustainability indexes outperformed their non-ESG equivalents; an improvement on 27 per cent outperformance in 2022 but a fall from 57 per cent in 2021.

Investors who chose to shun the carbon intensive energy sector last year were rewarded with climate and net-zero aligned indexes reporting a strong year, with 67 per cent outperforming their broad-based benchmark. 

Robert Edwards, Director of Product Management, EMEA and ESG Indexes at Morningstar, says tilts away from the energy sector and toward technology and consumer cyclicals were the main drivers of the outperformance in these indices.

“Climate indexes, such as those focused on net-zero alignment, had a bounce back year, helped by above-market exposure to the technology sector. These indexes also benefited from tilting away from high carbon intensive sectors, which underperformed in 2023,” he says.

However, indexes focused on best-in-class security selection – which select the lowest ESG Risk stocks within a sector – generally performed poorly in 2023. 

Edwards explains this underperformance resulted from avoiding the top-performing so-called “Magnificent Seven” stocks.

“Meta and Alphabet were left out of the Morningstar Global Sustainability Index because of ESG controversies, while Tesla and Amazon were excluded because of relatively high ESG risk within their respective sectors,” Richard says.

Data collection and privacy issues have long seen Meta – formerly Facebook – perform poorly in ESG ratings – it is currently considered high risk by Sustainalytics. Meanwhile Alphabet – the parent company of Google – faces class action lawsuits for misusing personal information and is ranked medium risked by Sustainalytics.

Tesla, the electric vehicle manufacturer and darling of the green transition, is accused by a group of 17 investors holding a combined USD1.5 billion of Tesla stock, of poor human capital management, including reports from workers and regulators that “point to a toxic culture at Tesla factories” which triggered multiple lawsuits alleging racial discrimination, sexual harassment, hostile work environments and anti-union activity.

Finally, Amazon.com is classified as high risk by Sustainalytics and is a poor ESG performer in its sector, which leads to it being excluded from or heavily down-weighted within most ESG-Risk-based indexes.

Edwards says: “Security selection and the exclusion of high-performing technology and communications stocks because of ESG screens explains much of the underperformance for the sustainability indexes in 2023. In the Morningstar Global Markets Sustainability Index, above-market exposure to stocks like Microsoft and Nvidia boosted performance returns but could not make up for missing out on Tesla, Alphabet, and Amazon.”

The challenge that such mixed performance brings to responsible institutional investors is how to balance a commitment to every part of ESG, while still honouring performance promises to their beneficiaries.  

For example, the Morningstar Sustainability Tilt indexes aim to minimise portfolio-level ESG risk while delivering diversified exposure similar to their parent indexes, the Morningstar Global Markets indexes. The tilt indexes exclude companies exposed to tobacco, controversial weapons, and civilian firearms, as well as severe ESG-related controversies and companies out of compliance with the United Nations Global Compact. But in making such exclusions, as evidenced by the omission of Magnificent Seven stocks in 2023, can be detrimental to returns. Meanwhile excluding high-carbon emitting stocks proved beneficial.

Consequently, despite outperformance from some sustainable investment indexes, investors still have much to think about when it comes to balancing the need to do good with meeting their fiduciary duty. 

Just consider financial markets and economics in 2023. If you asked a professional forecaster last year at this time whether the US economy would slump in 2023, nearly two-thirds would have answered in the affirmative. 

Similarly, at this time last year, the bond market was convinced (or at least many investors placing bets were) that the Fed would end its rate-hiking campaign at 5 per cent and then cut rates two to three times by the end of 2023. 

Here are some of the top confident views Payden’s economics team are hearing that could be wrong for 2024:

“A recession is inevitable in 2024.” Coincidentally, this was also the top view espoused by many investors and most (65 per cent) of professional forecasters last year. A recession did not occur in 2023, but even with all the “soft landing” lip service, the professional forecasting community still puts a 50 per cent chance of one in 2024. Will consensus get it right in ’24? We doubt it. We think the chance of a downturn in 2024 is closer to 12.5 per cent. Instead, we expect at or slightly above-trend GDP growth powered by the resilient U.S. consumer. 

“…but the US. consumer is running out of savings!” To steal from Twain, rumours of the US consumer running out of savings have been greatly exaggerated. The personal savings rate has declined as consumer spending patterns normalised post-pandemic. However, the aggregate US consumer still sits on trillions in savings. More importantly, consumer spending and, thus, overall US economic activity growth is driven by income growth, not savings. Income growth remained robust through November 2023.

“The US government will not be able to finance its massive deficit.” As mentioned above, the U.S. budget deficit has widened, but the appetite from U.S. and global investors for Treasuries remains strong. Also, Treasury bill issuance financed much of the 2023 deficit, with US households and businesses enthusiastic buyers. And the US devotes less than 3 per cent of US economic output to paying US debt service costs, a manageable task for now.

“Stubborn inflation may force the Fed to overtighten, tipping the economy into a recession.” While we were more amenable to such views at mid-year with the economy running hot at 5 per cent GDP growth, flash forward six months, we see much more reason for optimism on the soft landing front. The six-month moving average of Core PCE’s monthly rate of change arrived in line with the Fed’s target of 0.2 per cent in October, and the unemployment rate remains near cycle lows. While we doubt the Fed will be quick to “declare” victory over inflation, we think it will take a few more months of data to seal the deal. As to claims the Fed’s recent “pivot” is due to politics (i.e., next year’s election), we’d point investors to the last six month’s core PCE data.

“Cracks are already appearing in global labor markets, and other central banks (ECB, BoE, BoC) will follow the Fed and soon start cutting.” Except for the UK and Canada, other major developed countries have fared better than many think. In addition, some central banks are even closer to achieving inflation goals than the Fed. For example, Canada’s core inflation sits just outside the central bank’s 1-3 per cent target zone. As a result, most central banks may cut less aggressively than markets predict, and the Fed will probably not lead the way, given the US labour market’s strength. That said, a significant source of financial market stress of the last 24 months—central banks moving aggressively to tighten financial conditions—has been removed from the equation. Finally, the BoJ shows little intention of tightening policy, another market dagger that may not materialise. 

“Escalating geopolitical issues will derail the global economy.” While tragic and unfortunate, geopolitical events tend to have a short-lived impact on markets and economic trends. Absent a sharp oil shock—a surge in oil prices that pinches the consumer pocketbook as we saw in 2008—a severe downturn induced by geopolitical events remains a low-probability scenario. 

“There’s no way credit/equities can rally from here.” First, fixed income is attractive based on absolute and inflation-adjusted bond yields compared to recent history. Second, the “soft landing” scenario—in which the Fed could fine-tune interest rates, rate volatility subsides, the U.S. dollar softens, inflation moderates, and the economy continues to grow—is a splendid recipe for credit sectors in the fixed-income market (equities, too!). Finally, to the question that tops bond investors’ minds—where are policy rates heading next year? Well, we again offer you a range of possibilities depending on the future path of inflation. (Ultimately, we expect the Fed to cut rates less than what markets predict, which might disappoint investors in the short term. As Fed Chair Jerome Powell said at the December FOMC press conference, the future can “evolve in many different ways.”

Ultimately, the goal is not to get everything right but to identify all the possibilities and eliminate errors so we are well-positioned for what might happen next. 

We’ll give Pericles the final say as his words have survived 2,500 years: “The key is not to predict the future but to prepare for it.”

This material has been authorised by Payden & Rygel Global Limited, a company authorised and regulated by the Financial Conduct. Authority of the United Kingdom, and by Payden Global SIM S.p.A., an investment firm authorised and regulated by Italy’s CONSOB.

The firm writes that was most welcome after the bond and equity market traumas of 2022 when the vast majority of private clients experienced significantly negative returns. But, generally, 2023 gains have not fully compensated for 2022 losses, the firm says. 

Local currency gains were highest for USD investors, but when adjusted for currency moves, returns for private clients in the same risk category were similar regardless of reference currency. After the painful normalisation of interest rates in 2022, bond markets seemed to offer reasonable value and, despite tighter monetary policy and the threat of recession, company profits proved resilient, the firm says. 

Yet, the ARC writes, the breadth of equity market gains was extremely narrow, the rise in the world equity market index being driven by the 10 largest US-listed “mega-cap” stocks (Alphabet, Amazon, Apple, Berkshire Hathaway, Broadcom, JP Morgan, Meta, Microsoft, Nvidia and Tesla). In 2023, these stocks were up, on average, circa 90 per cent and up around 85 per cent on a market capitalisation-weighted basis, with the other 490 stocks making up the S&P 500 on average delivering a return of zero.

Dan Hurdley, Managing Director ARC Research, says: “The good news for investors continued in December with most financial markets generating positive returns for the month with the energy and commodity sectors being the notable exceptions. The prospect of falling interest rates helped more cautious investors as yields for both government and corporate bonds fell again in December. 

“On the back of strong performance in November, all currencies and risk categories of the ARC Indices are expected to show positive returns for the quarter and the year. The falling rate of inflation means that investors in all indices can also expect positive returns in both nominal and real terms for 2023.”

“Demographics” also serves as a catch-all excuse for many macro views. Some say interest rates  will revert to pre-Covid levels in the developed world due to weak demand (“It’s demographics!”),  while others worry about runaway inflation due to faster wage growth stemming from workforce  shortages (“It’s demographics!”). 

People production paramount 

Suppose you, dear reader, live long enough (say, the next 63 years). In that case, you may  experience something unseen in human history for at least the last 60,000 years: the peak and  prolonged decline in the size of the human population. 

That’s right, not since humans migrated out of Africa millennia ago has the number of humans  roaming the earth gone in reverse for any extended period. But by 2086, the human population  could peak at around 10.4 billion and begin to decline.

Why the decline? It won’t be because of climate change or a pandemic. Of all the supply chain  problems consumers have faced, one product’s production process is difficult to change: human  beings. 

Despite scientific advances, producing human offspring still requires a 40-week gestation  period—and then nearly two decades of care and comfort to create a fully functioning adult of use  to society (or longer for some). 

As such, for every two people choosing to produce offspring, only so many new children can  appear in the decades ahead. To “replace” the current population, the fertility rate—the average  number of children born to every woman—would need to be at least 2.1 (to account for more boys  being born than girls). Once we know how many people we have now and how many new ones  we can produce each year, we can guess how many people will exist in, say, 20 years.

Children are our future 

South Korea serves as the perfect example of declining birth rates. The South Korean fertility rate  has dropped 86 per cent since 1960, from almost six births per woman to 0.81 in 2021! According to the  United Nations’ World Population Prospects report, South Korea’s population could fall by around  20 million in the next 50 years. That is despite the United Nations’ slightly higher fertility rate  projections! 

China, often the poster child for discussions of demographic doom, faces a similar predicament.  China’s fertility rate is already down to 1.16 births per woman, so China’s population could decline  by around 654 million in the decades ahead from the current tally of 1.4 billion. 

Interestingly, India may fare best (at least if the goal is to have more people!). Based on current  figures, the long-term population of India could reach 1.7 billion, around 600 million more than  China’s at that point. Imagine the geopolitical consequences. 

However, India may fall well short of 1.7 billion people. India’s fertility rate is already at 2.0. And  India’s overall fertility rate is 1.6 in urban areas, well below the replacement rate.

Africa is the exception, but as per capita incomes rise, fertility rates usually fall, as seen  elsewhere. Also, Africa will likely need more time to grow to offset shrinking populations  elsewhere.

Overall, the total world fertility rate was 2.27 in 2021, according to the World Bank. When will the world rate dip below the 2.1 threshold? Possibly as soon as the next two decades. 

Nothing’s inevitable 

Fertility rates could pick up, whether through government incentives, cultural shifts, or  technological advances—nothing is inevitable. 

Moreover, many of our readers may rejoice over the population news (and some may even argue  it could not happen soon enough!). Fewer people equals less demand for natural resources.  Better for the environment, the story goes. 

Unfortunately, this story, though popular, is wildly short-sighted. 

First, global economies have already become less resource-intensive over the last few decades,  even as the population reached new global heights.

Second, at first blush, fewer people mean slower economic growth if productivity growth rates remain similar to historical norms. After all, economic growth is simply the number of people  working and the output they produce over time—productivity. In the US, for example, labour  productivity averaged ~2 per cent in the 50 years pre-Covid. With a 1 per cent workforce population growth,  overall economic growth trended at ~3 per cent annually. However, even with average productivity  growth, overall GDP will struggle to expand if population growth goes negative. 

A critical problem with a lack of economic growth is ballooning government debt. The only way to  overcome a debt problem is to be ever more productive to offset population decline. Otherwise,  the demographic burden will become a hefty fiscal burden, especially if public health and pension  costs also grow as aging occurs. 

Could productivity growth pick up to offset demographic decline? Advances in machine learning  provide some hope that technological advances could push  productivity upward, but the math is difficult to overcome. That said, there is hope: since the 1950s, only about 15 per cent (or 0.3 percentage points) of US economic growth is due to population growth. Rising educational attainment, more research & development, and a rising share of the  population working contributed more to growth. 

People generate problems but also solutions 

For us, the biggest problem of population decline is that fewer people will generate fewer ideas.  Some research indicates that ideas are becoming more difficult to find, and most growth comes  from new firms forming (based on new ideas). Fortunately, at least in the US, new firm formation  appears to be trending up.⁷ But we wonder whether this will persist with aging populations and shrinking labour forces?

College enrolment may suffer in the coming decades. Fewer children mean fewer  students, fewer graduates mean fewer professors, and fewer professors probably mean fewer colleges. As for the institutions themselves, the stronger names and brands will survive, but fewer students will be left for the lower-tier institutions. We already see evidence of this in South Korea, where total student enrolment has declined for 18 straight years.

It’s the demographics, stupid! 

Even a subject as seemingly simple as demographics, with some hard-to-argue-with math at its  core, leaves ample room for uncertainty about the future, especially as we stretch into the next  few decades, not just the next few years.

Nothing is predestined, but we hope this quick tour of the demographic landscape elucidates the  problems and possibilities we may face. 

This material has been authorised by Payden & Rygel Global Limited, a company authorized and regulated by the Financial Conduct. Authority of the United Kingdom, and by Payden Global SIM S.p.A., an investment firm authorized and regulated by Italy’s CONSOB.

The group writes that the Paper’s objective is to improve understanding of the benefits and risks of crypto market infrastructures and how they function.

The WFE Research paper analyses exchange interaction with the evolution of crypto-trading platforms across various jurisdictions and the opportunities or challenges that these new technologies bring. It studies how demand for crypto-related products and services is changing, and how regulated exchanges are responding to the opportunities and challenges posed by these technologies, including with the creation of regulated crypto-trading exchanges or the provision of crypto-related services.

Crypto-trading platforms have operated without the standards required from established public financial markets and with very little regulatory oversight. The WFE Research paper, titled, ‘A review of crypto-trading infrastructure’, studies how this offers a greater opportunity for illegal financial activities and the consequences for market integrity, and for investor protection.

The paper finds that the risks that unregulated crypto-trading platforms bring are compounded by the fact that they frequently carry out further activities that would not be permitted, or would be closely regulated, in mainstream public markets.

The Research studies the implications that the differences in model design between decentralised platforms (DEX) and centralised platforms (CEX) have on liquidity provision, price discovery and the custody of assets. It also analyses what these differences imply for fundamental aspects of financial markets regulation: anti-money laundering, prudential regulation, investor protection, and may imply for financial stability.

Dr Pedro Gurrola-Perez, Head of Research at the WFE, says: “There is a growing demand for crypto products and services. Crypto-related innovations are seen as an opportunity to advance technology development and increase investor choice, however, the lack of minimum governance and investor protection standards of unregulated crypto platforms, as well as the high volatility observed in these markets, and the risk of cybersecurity threats, is a concerning mix.”

Nandini Sukumar, CEO of the WFE, says: “Crypto is at the forefront of all of our members’ minds and we are in constant dialogue with them about how to capitalise on the new opportunities in the area. As this industry and market matures, coming in to the mainstream of financial markets, the exchange-traded model which places investor trust, transparency, accountability and investor protection at the heart of platform, will gain further momentum.”

Other findings include:

• Deal activity: By the end of Q2 2023, venture capital deal-making has trended downward for the sixth successive quarter with 4,485 deals completed, while aggregate deal value reached USD63.2 billion. The lower numbers are largely being driven by a sharp decline in consumer discretionary and healthcare deals. In terms of deal value, information technology has dragged down the total deal value.
• Exit trends: The number of exits and aggregate exit value are 30.6 per cent and 33.0 per cent lower than their five-year quarterly average, at 419 and USD52.9 billion, respectively, by Q2 2023. Exit pricing for assets has not been as high as in 2021, but if public markets continue to improve, more exit activity should occur in the second half of the year.
• Fundraising: Fundraising remains tough for fund managers looking to raise capital. The number of funds closing has been on a downward trend over the past six quarters, albeit with a slight uptick in the fourth quarter of 2022. Aggregate capital raised has followed a similar trend, with 219 funds raising USD26.1 billion by the end of Q2 2023. Investors remain pessimistic, but continue to deploy capital, although less than in the recent past.
• Funds in market: The significant overhang of funds in market trying to raise capital is affecting how long funds are spending on the road, with the overall time spent raising capital increasing since 2020. This is especially highlighted by the fact that seven per cent of funds took six months or fewer to close in the first half of 2023. This is in stark contrast with 2020, when 38 per cent of funds closed after a maximum of six months on the road.

Michael Patterson, Senior Associate, Research Insights, at Preqin says: “It has been a challenging time for venture capital firms looking to raise new funds. This trend looks to continue as investors have been more discerning with whom they are allocating capital to. Adding to this, the weak exit environment has dimmed appetite for late-stage strategies.”

Our Capital Market Assumptions for the next 10 years reflect that we are in the early stages of a significant and far-reaching macroeconomic regime change that was set in motion over the past three years.

A mismatch between high demand (driven by monetary stimulus) and impaired supply in the wake of the pandemic and the war in Ukraine, on top of longer-term demographic, geopolitical and economic shifts caused inflation to spike. The Federal Reserve and other central banks responded by raising interest rates and moving from quantitative easing to quantitative tightening.

While we are past peak inflation, we believe the risks of bouts of inflationary shocks over the next decade have increased. In our view, this new period will be marked by labor scarcity, commodity underinvestment, increased geopolitical uncertainty, and a move away from globalization and toward “friend-shoring” (i.e., trade partner selectivity).

Stubbornly higher inflation will likely result. We also factor in higher interest rates and lower real economic growth than in the last cycle in US and global economies. We believe greater volatility of macroeconomic factors and the global business cycle will also lead to more frequent cycles of slowdown and expansion versus what investors became accustomed to in the prior 35 years. In turn, this drives several notable aspects of our 10-year assumptions that differ from the prior decade, including higher yields, generally lower multiples and higher premiums for risk assets.

A closer look at fixed income

We expect fixed income returns to be higher over the next 10 years, and this assumption centres on the higher starting point for yields that exist today.

As inflation has risen, the Federal Reserve has engaged in one of its most aggressive rate-hiking cycles ever, which raises forward-return prospects across the fixed income universe.

Our expectation is that inflation will settle out around 3 per cent, driven by prevailing supply-side shortages in goods, commodities, housing and labour. The Fed will have difficulty achieving its old, and likely outdated, 2 per cent inflation target on a sustained basis.

As such, we don’t expect the return to normalization that the general market anticipates.

A closer look at equities

While yields are a rising tide that we expect to lift fixed income returns across the board, our expectations for equities are more subdued.

During the prior decade, earnings grew strongly, profit margins expanded, and multiples climbed. However, quantitative easing and accommodative monetary policy are gone, while growth is slowing. Slowing labor force growth will hold back economic growth, absent a strong revival in productivity. One development we are watching that could influence productivity is artificial intelligence (AI), with some observers estimating that productivity gains in AI could offset the expected decline in the labour force.

Our 10-year expectation for U.S. real GDP growth is 1.6 per cent, down 0.5 percentage points from the prior decade. Global GDP growth is also expected to be lower than the prior decade at 3.1 per cent, down 0.6 percentage points from the pre- pandemic trend. The primary driver of slowing US and global real GDP growth is a decline in working-age population growth.

As growth slows, costs are rising amid higher inflation. Notably, the labour share of income is climbing higher after a multi-decade trend lower, and companies are seeing lower net profit margins. A higher cost of capital is also likely to act as a restraint on profitability and earnings growth.

At the same time, a higher required risk premium will also likely drive down equity multiples. In other words, higher rates mean that investors can achieve higher yields with lower risk in fixed income, making risk assets, notably equities, relatively less attractive.

That’s particularly true for US equities, where our assumption is for annualized returns of 7.3 per cent over the next 10 years. These returns are only slightly above our assumption for emerging markets (7.2 per cent) and are lower than that for developed international markets (7.7 per cent); in these markets, valuations are relatively lower now and don’t need to adjust down, unlike valuations in US equities. Expected returns stand in stark contrast to the prior decade, when US equities outperformed emerging and developed international markets substantially.

Implications for real assets

The new market regime is driving higher expected returns for real assets.

Higher production costs, increased regulation, a scarcity of resources, and recent underinvestment will drive returns in natural resource equities and commodities over the next 10 years. At the same time, resource producers have faced revenue pressures for years and have instilled greater supply-side discipline and a greater focus on profitability. Better growth and higher profitability also support valuations of resource equities.

Higher expected returns for commodities, as measured by the Bloomberg Commodity Index, are also driven by higher production and extraction costs, which are the result of inflation, as well as by a longer-term shift as we move from a period of oversupply to one of undersupply. Higher expected collateral returns (in light of higher expected interest rates) will also contribute to commodity total returns.

We also expect infrastructure to perform well given predictable cash flows and the fact that many infrastructure subsectors—such as airports, marine ports, midstream energy, toll roads and towers—have revenues that adjust with inflation.

Indeed, infrastructure has historically produced above-average returns when inflation has been high but moderating. We also expect investor demand for infrastructure to remain high, as the asset class generally has lower volatility than the broader stock market due to its relative earnings stability.

In the expected higher-inflation/lower-growth environment, we believe that REIT cash flows will remain resilient and that constrained new supply will benefit real estate prices (though lower economic growth could be a modest headwind). We expect US REIT returns to improve over the prior decade (8.2 per cent vs. 6.9 per cent annualised returns), while global REITs, benefiting from more attractive valuations in international markets, are expected to improve more sharply (8.0 per cent vs. 3.8 per cent annualised returns).

Listed and private real estate returns tend to be similar over long periods, but private real estate typically lags listed real estate due to its slower-moving price discovery and transactions. Listed real estate had sharp declines in 2022, while private real estate had only modest declines. We expect average private core real estate (7.0 per cent vs. 9.7 per cent annualiaed returns) to trail listed markets as this gap closes.