Where are the opportunities? Multi Asset’s long term return expectations

Your, or your clients capital is at risk.

Long Term Return Expectation (LTRE)

The macroeconomic environment changed markedly in the final quarter of 2023 as it became clearer that inflation was moving firmly towards central bank target levels. Accordingly, the narrative conveyed by central banks also changed, with the balance of risks moving more towards protecting growth. That being said, inflation is still the policy priority of most developed market central banks, hence they are maintaining interest rates at relatively high levels.

Against this improving inflation picture, the growth backdrop remained relatively stable, albeit US exceptionalism offset weaker growth in Europe and China. But this overall stability in growth, alongside falling inflation, is a ‘goldilocks’ outcome akin to immaculate disinflation: central banks have succeeded in bringing down inflation without forcing a recession. This has been a boon to asset markets, with bond and equity markets performing strongly into year-end.

However, the journey is not complete. Much of the reason behind the recent fall in inflation has been the reversal of the supply chain disruptions caused by the increase in demand for goods during the pandemic. However, the robustness of the US labour market and relatively high wage inflation are still a threat to the Federal Reserve consistently achieving its inflation target of 2 per cent. This is something it will be acutely aware of when thinking about forward policy guidance.

The challenge now, therefore, is to bring down inflation in the service sector, which is more closely tied to wages than economic growth. To get to this point, financial conditions would likely have to tighten, meaning growth would slow down and asset prices would fall.

This tightrope leaves us erring on the side of caution. If growth continues to slow, we risk a rapid economic deceleration as restrictive policies stay focused on inflationary concerns. However, if policy is loosened too soon, thus allowing growth or inflation to surprise on the upside, a rapid resumption of interest rate hikes would not be inconceivable.

Putting doom and gloom to one side for a moment, while there is a relatively narrow path to follow, economic activity has so far managed to avoid wandering off a cliff. Most probably, central banks will be quietly pleased with current progress.

In summary, it is our view that inflation will continue to moderate, dropping back towards central bank targets in the short-to-medium term. We expect consumer demand to continue easing, although low unemployment rates and continued wage inflation pose the most significant risks to the contrary.

Growth

We have increased our growth forecasts for most economies as artificial intelligence (AI) and industrial policy delivered a boost to productivity. Our forecasts for average inflation-adjusted growth for the US have increased to 2.2 per cent, for the Eurozone and Japan to 1.4 and 1.3 per cent respectively, and for the UK 1.8 per cent over the next 10 years. Across this cohort, we expect the labour force to stagnate due to an ageing population and lower immigration, so all the increase in growth should come from productivity. This is higher than seen in the last decade, though still below the levels experienced during the productivity surge of the 1990s.

For further insights into productivity growth, we have published two papers on our website – The Productivity Surge of the 2020s, and Productivity growth: unravelling the slowdown and forecasting a pick-up.

For emerging markets, excluding China, we forecast real growth of 3.5 per cent, also boosted by AI and industrial policy. We reduced our baseline expectation here given the change in the Chinese growth model and our view that significant economic stimulus from the government is unlikely.

We expect China’s economy to slow over the next decade but still register a respectable 3.4 per cent real growth rate. The shift will follow its transition from an investment-led economic model to one oriented toward domestic consumption.

Inflation

As noted, we expect inflation to converge towards central bank targets over the next decade. The reasons for this include:

• Central banks remain determined to return inflation to their respective targets, their interest rate increases are aimed at curbing demand.
• Supply shortages have eased. Some industries that saw constrained capacity, such as semiconductors and shipping, may well move into oversupply in the medium term, provided the absence of any exogenous geopolitical shock.
• The Bank of Japan remains seemingly comfortable with highly supportive monetary and fiscal policies, further supporting higher inflation expectations.

Because of high inflation following the pandemic, we had expected central banks to follow a policy of average inflation targeting (AIT) which waits for long-term averages to exceed targets before adjusting interest rates, thus requiring below-target inflation for a time. However, because no central bank has demonstrated this approach over the last year, we have reduced our expectations of this occurring and our average 10-year forecasts have therefore increased slightly.

For example, in the US, we expect annual consumer price inflation (CPI) to fall only briefly from its current 3.4 per cent rate to below its longer-term target of 2.0 per cent, before returning to target for the rest of the decade. That produces an average 10-year inflation figure of 2.2 per cent.

Using the same approach gives us expected inflation of:

• 2.3 per cent in the UK
• 1.9 per cent in the Eurozone
• 1.8 per cent in Japan
• 1.8 per cent in China
• 3.8 per cent in emerging markets outside China

We recognise that this scenario may be wrong, and we remain vigilant regarding some of the forces that might give rise to higher inflation. These include:

• A shift in political and central bank attitudes, which could lead to inflation targets being de-prioritised or raised.
• More fiscal spending, such as increased defence and infrastructure spending.
• Demographic change, where labour participation rates fall, tightening labour markets and raising wage inflation.

Policy rates

We believe policy rates are currently at their peak in all major markets for this economic cycle. We expect that they will begin to fall as inflationary pressure eases, because central banks do not want to tighten policy further by allowing the ‘real rate’ – the difference between interest rates and inflation – to rise further. This path should facilitate lower bond yields of longer maturities, albeit the scale of interest rate cuts matters. In thinking about their future trajectory, we place significant weight on factors such as the high levels of global savings, which will also support bond yields.

We expect the significant rise in policy rates we have just witnessed to be a relatively short-term phenomenon. We think the US policy rate has peaked at 5.4 per cent, but over the decade it should settle at its neutral level of 2.9 per cent. Our view on this neutral rate has increased 0.9 per cent, reflecting the work we have done on AI and industrial policy that has raised our growth expectations, but also our view of increased risks emanating from geopolitics, government debt levels and uncertainty over inflation.

Similarly, while more policy tightening in the Eurozone and UK is very plausible in the short term, we expect cash rates to fall from their current levels to finish the decade at 1.9 per cent and 2.7 per cent, respectively.

Asset class outcomes

Following the sharp reversal in yields at the end of the year, developed market bond returns are much less attractive versus cash, although they could still provide further positive and diversifying returns in a recession outcome. Given this is something we still assign a reasonable probability to, we have maintained a modest allocation to longer-dated bonds issued by Australia and Canada and, to a lesser extent, the US.

We are still positive about emerging market local currency government bonds, where we forecast a 10-year return of 2.75 per cent above cash. Central banks in the emerging world responded to the rise in inflation by raising interest rates sharply and more quickly than developed market central banks, and are now starting what we expect to be significant easing cycles over the coming years as inflation subsides.

Similarly, we think hard currency emerging market bonds (those priced in major currencies such as US dollars or euros) can perform well from elevated spreads, which we believe overstate long-run credit risk. We forecast a return of 4.25 per cent above cash.

In mainstream credit markets (investment grade and high yield), returns are lower than our last iteration. However, spreads above risk-free rates in the structured finance market reflects more default risk than will materialise. We expect this asset class to continue to deliver good long-term returns. In the case of mezzanine bonds, we project a return over cash of 5.75 per cent per annum over the next 10 years.

Recent increases in equity markets have made them less attractive. We forecast that returns over the next decade from a global, passive portfolio of 2.50 per cent above cash will still be lower than the very long-run expected outcome of 3.25 per cent.

Part of this is because corporate profit margins have moved to historically high levels, especially in the US. To be clear, we do not expect a sharp reversal of historical averages. Indeed, we think there are many companies in the US and elsewhere capable of sustaining high margins for many years. But we believe it will be difficult for the whole market to continue generating this profitability level over the very long term. Our forecast, therefore, anticipates a modest degree of future margin compression.

In property, our expected returns are higher than equities at 4 per cent over cash. We expect good outcomes from logistics property in particular. The sector should benefit from growth in ecommerce and the lack of adequate warehouse supply in many regions.

In infrastructure, we think the transition from fossil fuel-based generation to new forms of energy provides a significant growth opportunity for both regulated utilities and renewable energy developers and operators. This underpins our 10-year forecast of 6 per cent returns over cash for core infrastructure.

Risk factors

The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication was produced and approved in March 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.

All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.

The images used in this communication are for illustrative purposes only.

Important information

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.

Baillie Gifford Overseas Limited provides investment management and advisory services to non-UK Professional/Institutional clients only. Baillie Gifford Overseas Limited is wholly owned by Baillie Gifford & Co. Baillie Gifford & Co and Baillie Gifford Overseas Limited are authorised and regulated by the FCA in the UK.

Persons resident or domiciled outside the UK should consult with their professional advisers as to whether they require any governmental or other consents in order to enable them to invest, and with their tax advisers for advice relevant to their own particular circumstances.

Financial Intermediaries

This communication is suitable for use of financial intermediaries. Financial intermediaries are solely responsible for any further distribution and Baillie Gifford takes no responsibility for the reliance on this document by any other person who did not receive this document directly from Baillie Gifford.

Europe

Baillie Gifford Investment Management (Europe) Limited provides investment management and advisory services to European (excluding UK) clients. It was incorporated in Ireland in May 2018. Baillie Gifford Investment Management (Europe) Limited is authorised by the Central Bank of Ireland as an AIFM under the AIFM Regulations and as a UCITS management company under the UCITS Regulation. Baillie Gifford Investment Management (Europe) Limited is also authorised in accordance with Regulation 7 of the AIFM Regulations, to provide management of portfolios of investments, including Individual Portfolio Management (‘IPM’) and Non-Core Services. Baillie Gifford Investment Management (Europe) Limited has been appointed as UCITS management company to the following UCITS umbrella company; Baillie Gifford Worldwide Funds plc. Through passporting it has established Baillie Gifford Investment Management (Europe) Limited (Frankfurt Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in Germany. Similarly, it has established Baillie Gifford Investment Management (Europe) Limited (Amsterdam Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in The Netherlands. Baillie Gifford Investment Management (Europe) Limited also has a representative office in Zurich, Switzerland pursuant to Art. 58 of the Federal Act on Financial Institutions (“FinIA”). The representative office is authorised by the Swiss Financial Market Supervisory Authority (FINMA). The representative office does not constitute a branch and therefore does not have authority to commit Baillie Gifford Investment Management (Europe) Limited. Baillie Gifford Investment Management (Europe) Limited is a wholly owned subsidiary of Baillie Gifford Overseas Limited, which is wholly owned by Baillie Gifford & Co. Baillie Gifford Overseas Limited and Baillie Gifford & Co are authorised and regulated in the UK by the Financial Conduct Authority.

Hong Kong

Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 is wholly owned by Baillie Gifford Overseas Limited and holds a Type 1 and a Type 2 license from the Securities & Futures Commission of Hong Kong to market and distribute Baillie Gifford’s range of collective investment schemes to professional investors in Hong Kong. Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 can be contacted at Suites 2713-2715, Two International Finance Centre, 8 Finance Street, Central, Hong Kong. Telephone +852 3756 5700.

South Korea

Baillie Gifford Overseas Limited is licensed with the Financial Services Commission in South Korea as a cross border Discretionary Investment Manager and Non-discretionary Investment Adviser.

Japan

Mitsubishi UFJ Baillie Gifford Asset Management Limited (‘MUBGAM’) is a joint venture company between Mitsubishi UFJ Trust & Banking Corporation and Baillie Gifford Overseas Limited. MUBGAM is authorised and regulated by the Financial Conduct Authority.

Australia

Baillie Gifford Overseas Limited (ARBN 118 567 178) is registered as a foreign company under the Corporations Act 2001 (Cth) and holds Foreign Australian Financial Services Licence No 528911. This material is provided to you on the basis that you are a “wholesale client” within the meaning of section 761G of the Corporations Act 2001 (Cth) (“Corporations Act”).  Please advise Baillie Gifford Overseas Limited immediately if you are not a wholesale client.  In no circumstances may this material be made available to a “retail client” within the meaning of section 761G of the Corporations Act.

This material contains general information only. It does not take into account any person’s objectives, financial situation or needs.

South Africa

Baillie Gifford Overseas Limited is registered as a Foreign Financial Services Provider with the Financial Sector Conduct Authority in South Africa.

North America

Baillie Gifford International LLC is wholly owned by Baillie Gifford Overseas Limited; it was formed in Delaware in 2005 and is registered with the SEC. It is the legal entity through which Baillie Gifford Overseas Limited provides client service and marketing functions in North America. Baillie Gifford Overseas Limited is registered with the SEC in the United States of America.

The Manager is not resident in Canada, its head office and principal place of business is in Edinburgh, Scotland. Baillie Gifford Overseas Limited is regulated in Canada as a portfolio manager and exempt market dealer with the Ontario Securities Commission ('OSC'). Its portfolio manager licence is currently passported into Alberta, Quebec, Saskatchewan, Manitoba and Newfoundland & Labrador whereas the exempt market dealer licence is passported across all Canadian provinces and territories. Baillie Gifford International LLC is regulated by the OSC as an exempt market and its licence is passported across all Canadian provinces and territories. Baillie Gifford Investment Management (Europe) Limited (‘BGE’) relies on the International Investment Fund Manager Exemption in the provinces of Ontario and Quebec.

Israel

Baillie Gifford Overseas Limited is not licensed under Israel’s Regulation of Investment Advising, Investment Marketing and Portfolio Management Law, 5755-1995 (the Advice Law) and does not carry insurance pursuant to the Advice Law. This material is only intended for those categories of Israeli residents who are qualified clients listed on the First Addendum to the Advice Law.

Ref: 91700 10035757