The past two years have ushered in a generational change for markets. Gone are near-zero interest rates, low inflation, stable growth and long economic cycles that were observed for well over a decade.
While we believe the rate-hiking cycle is likely ending, we are now entering an environment that will be characterised by slower economic growth alongside higher and more volatile inflation.
In this environment, we believe fixed income will provide a higher return alternative to other asset classes than in the previous decade.
By comparison, equities are expected to be lower, facing elevated valuations, slower growth and wider cost of capital. However, we believe real assets should outperform both bonds and equities as the starting point for valuations is attractive.
While forecasters have consistently been too optimistic about inflation falling, we expect stickier inflation going forward, due to commodity underinvestment, tight labour markets, geopolitics and deglobalisation.
Diversifying beyond stocks and bonds with real assets is likely to become increasingly important in creating more efficient portfolios.
Fixed income – a higher return alternative?
The new regime of higher rates and higher-trend inflation has mixed implications for fixed income returns. The upside is that the recent rise in interest rates means that capital losses are likely behind us, and higher current yields are expected to generate good returns (3.9% per year) over the next decade.
That’s a significant difference from the previous regime (spanning 2012–2021), when there were only three months in which 10-year US Treasuries closed with a yield greater than 3%.
Following the growth and inflation rebound post-Covid, and aggressive central bank tightening, short-term rates have shifted higher, brushing up against 5% in 2023.
While a higher-for-longer cyclical environment has dominated market attention lately, neutral real rates are slightly lower than current levels, indicating Fed easing.
Regardless of the timing and number of rate changes, we do not expect rates to decline to pre-Covid levels. Indeed, our base case anticipates a terminal Fed funds rate of around 3% over the next decade.
The starting point for corporate credit markets is also relatively attractive from a yield perspective as these markets appear poised to outperform Treasuries. However, the starting point on spreads poses shorter-term risks in a slower-growth environment, which could lead to spread widening and a cyclical uptick in defaults.
Preferred securities had a strong year, returning 8.2% in 2023 despite the well-publicised banking sector turmoil. Looking ahead, we remain optimistic about preferreds’ return potential, including strong fundamentals, attractive valuations and the end of the rate-hiking cycle.
Equity returns are lowering
Global equity markets face several crosscurrents in the years ahead. Strong nominal growth should support top-line growth, particularly in the US, even if some margin compression is possible from currently elevated levels.
However, the starting point for valuations is less supportive in a higher–yield interest rate regime and given 2023’s strong performance, more than half of which is attributable to multiple expansion.
Combined, this suggests US equity returns of 7.0% over the next decade – far lower than the previous decade of 12.0%.
For developed international equities, with different drivers to the US, we anticipate slower-trend earnings growth due to declines in working-age population growth and relatively lower productivity.
However, these markets have higher dividend yields and more attractive valuation starting points to support returns. Therefore, we expect their total returns to be on par with the US moving forward.
Despite persistent underperformance, we believe emerging markets will continue to lag in coming years, given a continuation of structurally lower return on equity and potential headwinds to growth in China.
Attractive valuations for real assets
The world has transformed from an era of abundance to a regime characterised by ‘scarcity,’ with higher inflation, higher wage price pressures, a move away from peak globalisation and more geopolitical uncertainty.
This, alongside improved diversification of traditional portfolios, is a backdrop that is likely to support higher real assets prices, creating strong returns driven by growth and profitability.
For US listed REITs, we expect annualised returns of 8.0% over the next decade. Global listed REITs are expected to be similar (8.1%) given a slightly higher dividend yield and better valuations after lagging returns in 2023.
Listed (and core) private real estate returns tend to be similar over the long run, reflecting the likeness of the asset classes. During 2023, listed markets rose while private market returns were negative.
As a result, we expect somewhat higher returns in private markets (7.3%) in the next decade. Expected total returns for global listed infrastructure also appear attractive at 7.8% over the same period.
Commodity prices will be supported by the secular backdrop, including recent underinvestment in supply, investment in energy transition, and global geopolitics.
For commodity returns, a higher level of interest rates boosts the expected return on collateral, offset slightly by some drag from the roll yield.
This should support strong natural resource equity returns over the coming decade (8.8%), alongside low current valuations and high free cash flow growth.
Jeffrey Palma is head of multi-asset solutions at Cohen & Steers. The views expressed above should not be taken as investment advice.