The rate cut conundrum: Multi Asset’s long-term return expectations

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Inflation in the first half of 2024 proved quite volatile, with the first quarter seeing inflation rise quite significantly, particularly in the US, before rolling over in the second quarter. Although this volatility forced a few central banks to dial back their expectations for cutting interest rates, many developed countries have now started to lower their interest rates from post-Covid highs. For most of these countries, the rationale has been about inflation moving to target rather than reacting to weaker growth. This outcome has further boosted sentiment towards risky assets, with equities and corporate bonds performing well.

Against this improving inflation picture, economic growth is holding up and even accelerating in Europe. The rate cuts we see in Europe are evidence of how the central bank’s priority has been, and still is, very much on getting inflation moving to target before easing policy. In Asia, Chinese growth remains lackluster as it continues to cope with the unwinding of property markets, which has affected the region more broadly. Overall, the global economy is enjoying a ‘goldilocks’ scenario of falling inflation and steady growth.

‘The last mile is always the hardest’ is a commonly used phrase when bringing inflation back to target, and this year’s inflation volatility is testimony to that. It means that central banks will be cautious in their rate cuts and likely more reactionary to actual data rather than reducing on the expectation of lower inflation. Furthermore, labour markets in most countries remain robust, with relatively strong wage inflation. Unless there is a surprise slowdown in growth, there is no need for central banks to rush into rate cuts. This backdrop has led to markets performing very well with easy financial conditions. Tighter financial conditions can indeed cause weaker growth, but economies have adapted well to rising rates and prospered.

Risks remain, most obviously, that central banks' caution and looking in the rear-view mirror mean they cut interest rates too slowly, and growth slows more than expected, potentially even into recession. Another risk is that policy is loosened too soon because there are new drivers of inflation that central banks miss. This facilitates growth or inflation surprising to the upside, leading to interest rate hikes restarting.

In summary, we believe that inflation will continue to moderate, dropping back towards central bank targets in the short-to medium-term, with a risk that inflation remains higher for longer because of strong labour markets and wage inflation. So yes, central banks will cut interest rates, but they are in no hurry to do so.

In the following table, we outline our expectations for interest rates and inflation over the next 10 years and beyond, taking account of real growth rates and expected boosts from productivity. Our expectations for asset class returns are above the cash rate on a passive basis, therefore we believe we can add to these figures with active stock selection.

In this summary table and at the end of the asset class outcomes section, we have rounded our forecasts to the nearest 0.25 per cent. This permits a sufficient distinction between asset class returns while avoiding spurious accuracy in our forecasting. Consequently, there may be instances in which numbers quoted in the text do not add up to the stated forecast.

Growth

Following the productivity boost from our recent research into Artificial Intelligence (AI) and industrial policy, as well as the upgrades from our last meeting, we have kept our growth forecasts for most economies unchanged. Our forecasts for average inflation-adjusted growth for the US are 2.2 per cent, for the Eurozone and Japan 1.4 and 1.3 per cent respectively, and for the UK 1.8 per cent over the next 10 years. Across this group, we expect the labour force to stagnate due to an ageing population and lower immigration, so 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 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 there is no exogenous geopolitical shock.
• The Bank of Japan remains comfortable with highly supportive monetary and fiscal policies, further supporting higher inflation expectations, which are currently still below target.

Central banks continue to avoid explicitly referencing average inflation targeting (AIT), which waits for long-term averages to deviate from target before adjusting interest rates. Following the Covid inflation spike, this would have required a period of below-target inflation. There has not been any change in this expectation since our last meeting and so our inflation expectations are unchanged.

In the US, we expect annual consumer price inflation (CPI) to fall only briefly from its current 3.0 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:

• 2.2 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 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 except Japan for this economic cycle. We expect 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, which means they would increase in price, 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 bonds.

We expect the significant rise in policy rates we have just witnessed to be a relatively short-term phenomenon. That said, we have increased our assumption for the long-term neutral rate in several countries. We think the US policy rate has peaked at 5.4 per cent but will settle at 3.3 per cent vs the 2.9 per cent we expected previously. This reflects the resilience of the US economy to the current level of interest rates while also reflecting risks emanating from domestic politics, geopolitics, government debt levels, and uncertainty over inflation.

Similarly, in the Eurozone and UK, we expect cash rates to fall from their current levels to finish the decade at 2 per cent and 3 per cent respectively, an increase from our last meeting of 0.1 per cent and 0.3 per cent, respectively.

Asset class outcomes

Following a rise in yields, developed market bond returns are slightly more attractive versus cash, and we maintain a small allocation to longer-dated bonds in Australia and the US. We still assign a reasonable probability to a sharper growth slowdown, in which these assets would perform very strongly.

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 they 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 is the amount of yield paid above that of US government debt), which we believe overstate long-run credit risk. We forecast a return of 4.5 per cent above cash.

Returns in mainstream credit markets (investment grade and high yield) are similar to our last iteration. However, following considerable spread tightening (yields have reduced relative to government debt), our return expectations have fallen sharply. Still, spreads above risk-free rates in the structured finance market reflect more default risk than will materialise. We expect this asset class to continue to deliver good long-term returns. For mezzanine bonds, we project a return over cash of 4.25 per cent per annum over the next 10 years.

Recent increases in equity markets and a rise in our expectations for policy rates have made them less attractive. We forecast that returns over the next decade from a global, passive portfolio of 0.75 per cent above cash will still be lower than the long-run expected outcome of 2.75 per cent.

This is partly 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 many companies in the US and elsewhere are capable of sustaining high margins for many years. However, 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 need for 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.

You can find more Multi Asset related content on the insights section of our website. Please contact us if you have any questions regarding this article or any other query related to the strategy.

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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 August 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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