Double-digit returns from US and global equities will be consigned to the history books as the factors underpinning US exceptionalism and high valuations dissipate, according to Pictet Asset Management.
Overall, global equities will deliver 7.6% per annum for the next five years, but the way to generate much higher returns going forward will be to choose the right sectors, said chief strategist Luca Paolini.
Technology, healthcare and industrials will benefit from innovation and artificial intelligence (AI), ageing populations, climate change and protectionism. These three sectors should outperform global equity benchmarks by a cumulative 20% over the coming five years, he said.
“These industries are pivotal in resolving some of our greatest long-term challenges, namely climate change, fraught geopolitics and growing labour shortages. In other words, in times of increasing uncertainty, we seek exposure to sectors that are the problem solvers,” he explained.
Pictet expects returns from growth and value strategies to be more evenly balanced over the next five years. Growth strategies will benefit from developments in AI but value strategies with a higher weighting to industrials will profit from onshoring, nearshoring and “muscular industrial policy”, Paolini added.
The markets that will do well
From a geographical perspective, Pictet is expecting annualised returns of 7.5% from US equities over five years – still around the world average but below its recent dominance. “Elements of US exceptionalism are rolling over,” Paolini said. He thinks low taxes and record amounts of government spending are unsustainable, while US leadership in AI and GLP-1 weight loss drugs will boost growth only marginally.
The S&P 500 is trading at a price-to-earnings (P/E) multiple of 21x compared to a long-term historical average of 16x. Paolini thinks a P/E multiple of 19x would represent fair value over the next five years and said the stock market’s current rich valuations will compress long-term returns.
US exceptionalism will not necessarily go into reverse but it will pause, giving other regions the chance to catch up, he predicted.
Emerging market companies in particular are getting better at translating economic growth into earnings growth and India is the world’s fastest growing region, he said.
Pictet expects emerging market equities to return 8.3% per annum in US dollar terms for the next five years and Latin American equities to do even better, returning 8.5%, as the chart below shows.
Five-year return forecasts in US dollar terms
Source: Pictet Asset Management, Refinitiv, Bloomberg
Inflation is a headwind for emerging market stocks – which explains their flat performance this year – but if inflation normalises and the global economy holds up, then emerging market equities should perform well, Paolini explained.
The UK and Europe are falling behind
Languishing at the bottom of the league table are UK and eurozone equities, which are projected to return 6.7% and 6.8%, respectively.
The UK is a defensive market full of well-managed, cheap companies but it does not have a vibrant or large technology sector so the market is “not very exciting”, Paolini admitted.
Arun Sai, senior multi-asset strategist, described the UK as a “stagflation play” because of its exposure to commodities. “You would need a peculiar macro set up for the UK to out-deliver on earnings versus global peers,” he noted. “The UK is essentially defensive value.”
A word on bonds
Turning to fixed income, total returns from 10-year US government bonds are forecast to be 5.6% on an annualised basis for the next five years, with 10-year Treasury yields settling at 3.75%. This means that equities will still outperform bonds, but by a relatively slim margin, as rising bond yields enhance the appeal of fixed income.
Paolini suggested that asset allocators move some money out of equities into credit, predicting a 6.3% annualised return from US investment-grade bonds. Returns from corporate bonds are likely to be on a par with equities, but with less risk and lower volatility as default rates remain benign.
Currencies and alternatives
Currency movements will assume greater relative importance going forward as they will eat into the muted returns that Pictet expects equities and most other asset classes to deliver.
Pictet predicts that the US dollar will weaken gradually by 2% per annum over the next five years, which will be a tailwind for local currency emerging market debt – an asset class that is forecast to return 8.9% per annum, beating hard currency emerging market debt and emerging market equities.
Meanwhile, Paolini believes investors should maintain exposure to alternatives and real assets but he acknowledged that these strategies are less attractive relative to listed assets than in the past.
In private equity, private debt and real estate, the gap between the best and worst performing managers is “massive” so manager selection is more important than asset allocation, he said.