By Jeffrey Palma, head of multi-asset solutions and John Muth, macro strategist at Cohen & Steers
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 The Fed will have difficulty achieving its old, and likely outdated, 2 per cent inflation target on a sustained basis.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.
