Achieving attractive real returns over the next five years will be no easy feat. Investment strategies need an overhaul. Economic growth will languish below the long-term average, with inflation volatile. Major developed economies will grow 1-1.5 per cent per annum on average over the next five years. Lacklustre growth isn’t the only challenge facing investors – they will also have to contend with the effects of a reduced global workforce and more state interventionism.
Equities: a less forgiving investment landscape
Uninspiring economic growth will dampen corporate earnings prospects while stocks’ valuations aren’t especially attractive.
Making matters more complicated is that allocating capital across national stock markets and regions is unlikely to prove particularly fruitful. Our forecasts show that the dispersion of returns across most major national and regional equity markets will narrow – nominal annualised returns will hover around 6-7 per cent in most cases in local currency terms.
For these reasons, we believe investors should adopt a more discerning approach and allocate capital to specific sectors in both developed and emerging markets and companies that enjoy strong pricing power.
The promise of the emerging world
Looking ahead, however, the case for investing in certain areas of the emerging world is strengthening.
Emerging Asia could be a rich hunting ground for equity investors.
Take southeast Asia in particular. A region with the fastest-growing economy, the ASEAN bloc will benefit from rising US-China tensions. As the world’s two largest economies reduce trade and investment between one another, we expect them both to redirect economic activity towards countries such as Vietnam, Indonesia and Thailand.
Some Latin American economies could benefit from the same trends. Mexican companies, for example, should gain from US efforts to bring manufacturing in auto and other value-added industries back to friendly shores.
Another potential boost to returns from emerging market stocks is shifts in the currency markets, where a marked depreciation in the dollar should enhance the appeal of riskier assets.
Stripping out the effect of a decline in the US dollar versus the renminbi, we expect Chinese equities to deliver a modest return of some 7 per cent per year.
We suggest investors to align their portfolio holdings with the government’s strategic priorities, and to allocate to sectors that exhibit secular earnings growth.
Developed markets: more challenging climate
When it comes to developed market equities, the outlook is less inspiring.
The operating environment for corporations based in advanced economies will become gradually more challenging in the coming years. Economic and financial conditions won’t be particularly favourable. Productivity will remain low while businesses can no longer count on ultra-low borrowing costs.
We believe effective corporate tax rates will rise by about 1 per cent every year in the US and UK and 0.5 per cent in the eurozone to help fund ambitious investment programmes such as the green transition. This increase in taxation is likely to be accompanied by the introduction of new levies on distributions to shareholders.
Together, these changes could reduce the investment appeal of developed market stocks in several ways. To begin with, increases in corporate tax rates will squeeze corporate earnings. We believe profit margins peaked in 2022 and forecast that margins in Europe and the UK will compress by a cumulative 10-15 per cent over the next five years.
Hotspots in equities
Overall, though, for dollar-based investors, Switzerland, the eurozone and China are likely to be the best-performing equity markets over our forecast horizon, with an average annual return of around 10 per cent in dollar terms. Switzerland has a high concentration of quality companies, such as manufacturers of consumer products, which have exhibited superior secular outperformance and should do particularly well in an uncertain low growth environment.
European equities, meanwhile, should benefit from attractive initial valuations and robust sales growth, although returns will be limited by a likely return of corporate margins to more sustainable levels.
Fixed income: Look to DM government bonds for cheap, defensive exposure and EM debt for returns
We expect US 10-year bond yields to be around 3.5 per cent by the end of our five-year forecast horizon.
Within developed sovereign bond markets, US Treasuries appear set to deliver the highest returns.
Credit markets, meanwhile, will deliver an unusually narrow spread of returns ranging between 4 per cent and 6 per cent.
We see value in US investment grade bonds – the balance sheets of high quality issuers are solid and an initial yield well above 5 per cent is attractive at the peak of a monetary policy tightening cycle.
Emerging market (EM) bonds will be boosted by the end of global monetary tightening, by positive trade developments as commodity prices trend higher, and by central banks regaining credibility on combating inflation. We expect spreads on dollar denominated EM debt to tighten by some 100bp to 400bp, resulting in a total return of slightly more than 8 per cent for EM sovereign debt denominated in US dollars.
The main boost to EM debt priced in local currencies will come from foreign exchange appreciation.
For investors in need of higher income, their best option is private debt. The asset class offers superior spreads. Given variable rates and with banks turning increasingly cautious about the loans they make, investors will have access to significant pocket of values. In this market, we are forecasting total returns of around 8 per cent in both Europe and US.
Alternatives: no longer optional
Both private equity and debt should outperform their public counterparts over a five-year time horizon. But the magnitude of that excess return will vary. For private equities we expect the premium to be 3 per cent annualised, which is below the long-term average.
For private debt, we forecast returns of about 8 per cent per year on average in both Europe and US in local currency terms; we believe this represents an attractive premium compared to returns of below 6 per cent on high-yield bonds.
The private debt market should prove an especially rich hunting ground for investors prepared to lock up some capital. As traditional banks are scaling back corporate lending, a growing number of businesses are turning to private institutions to secure funding.
But private debt enjoys other advantages over bonds. Because private loans are variable rate, the asset class offers investors protection from rising interest rates and volatile inflation.
Commodities should also perform well in the next five years –we forecast an annualised return of circa 9 per cent. Weaker economic growth is normally not good news for commodities, of course, the green transition and the re-industrialisation of developed economies will boost capital spending which is, by nature, commodity-intensive. This will come after a decade of severe underinvestment in raw materials extraction and refining, which has left most commodity markets with limited and less flexible supply, as well as historically low inventories. Industrial metals should benefit the most – we forecast annual price increases to be in the low double-digit percentage range per year over the next five years.
Gold continues to be a key strategic asset in our secular portfolios, but according to our models it has overshot fundamentals.
We expect good returns from property too, of some 6-8 per cent per year in local currency in major economies. But we must acknowledge that the current pricing in both Europe and US may not fully reflect the risk of significant writedowns in the commercial real estate, especially for offices and second-tier retail property, where demand for loans has fallen to record lows.
Luca Paolini is chief strategist at Pictet Asset Management.
