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What might stagflation mean for long-term return forecasts?

03 April 2023

Lukas Gehrig, Zurich Switzerland, Quantitative Strategist
Nikola Vasiljevic PhD, Zurich Switzerland, Head of Quantitative Strategy

Key Points

  • In our latest capital market assumptions (CMA), we look at global economic and financial market prospects for the next five years. The recent sell-off in equities has brought stocks back to more reasonable valuations, which points to a small increase in anticipated annual returns (to 7-8% for developed markets). While, bond returns have improved most since our previous CMA

  • Ageing populations have hit long-term growth projections for many countries in recent years. Increased labour force participation rates have filled the gaps in many developed economies over the last decade, but look to have peaked

  • UK and eurozone cash rates are expected to be below the inflation rate in coming years. Only US cash rates are expected to compensate for inflation

  • The next five years should be characterised by relatively high volatility, given elevated inflation levels and subdued global growth prospects, which are reflected in our CMA risk framework.

At a particularly febrile moment for investors, with heightened geopolitical risk, persistent inflationary pressure and the spectre of a global recession, this article examines our latest five-year outlook for financial markets. At times of market turmoil, it can help to stand back from short-term developments and focus on to longer-term prospects.

Formulating five-year assumptions represents different challenges than those that come with taking a view on what might happen in the next three months: structural changes in economies cannot be ignored, non-price aspects of financial investments, such as dividends, yields and roll return, compound and the role of uncertainty and volatility is more important than over shorter horizons.

Growth prospects: a bumpy landing into a sluggish recovery

Early last year, developed market central banks prepared to adjust monetary policy to try and target a soft economic landing. Over 12 months later and the jury is still out on how severe the landing might be.

In gauging prospects for the global economy, it is worth remembering that the interest rate hikes seen towards the end of last year have not yet been fully reflected in the labour market. Once they hit, a recession in developed market economies seems likely to ensue.

Next year, and beyond, is expected to be characterised by a sluggish recovery. Unlike the effect of the COVID-19 pandemic in 2020, when central banks rode to the rescue, this time around monetary policy stimulus may be largely withheld, so as not to reignite inflation. Furthermore, any fiscal stimulus will probably be administered only sparingly, as this could offset the demand destruction that central banks intend by hiking rates.

European economies, which are already suffering a cost-of-living squeeze, should fare worse than the US in the first years of our Capital Market Assumptions (CMA) forecast. Over five years, the average growth rate is projected to be worse than the average for the last ten years. This is also true for emerging markets. However, the reason for this is due to structural drivers weighing on growth rather than a substantial slowdown, which emerging markets should avoid on this occasion.

Participation rates can’t compensate for an ageing population

Cyclical woes aside, the longer-term growth outlook remains subdued by the availability of labour. Our estimates for potential growth, which set the anchors for longer-term growth rates, are affected by the demographic shift being seen in most economies.

Three factors determine the labour input of an economy: the labour force population, the labour force participation rate and the hours worked per worker.

The shrinking labour force population of the last decade has been balanced by increasing labour force participation rates in the UK (see chart). The US economy also relied on labour force participation increases starting from 2016 but has never really recovered from the declines in them in the aftermath of the global financial crisis.

Labour input is running out of steam
Labour running out of steam UK

The labour force participation rate and average hours worked figures displayed are average values across all working age categories. Ageing of the population has an effect on these measures too by shifting the weights of age groups over time. While we project participation rates for every age group and sex individually, we only show aggregate numbers here.

Artificial intelligence needs to be put to work

As the number of workers reaches its limits, technology is stepping up to fill the gaps. Productivity growth – boosted by the integration of artificial Intelligence (AI) into all aspects of the economy – should contribute more strongly to gross domestic product (GDP) growth over the next five to ten years than it has in the last decade.

Total factor productivity, which is where productivity-enhancing advances from AI integration would fall into in our framework, is projected to grow between 0.2% to 1.0% per year, depending on the country. For the UK and the eurozone in particular, this would mark an improvement from what was experienced between 2008 (and the global financial crisis) to 2020 (the pandemic).

Inflation to remain elevated

Inflation rates are expected to recede from their multi-decade highs seen in last year, but should remain above central bank targets well into 2024. Over five years, the average inflation rate is projected to lie around the target level for the US and clearly above target for the UK and eurozone.

There are clearly many risks to this forecast: for instance, a resurgence in geopolitical tensions during a cold winter could lead to a second oil price shock in the 2020s. Depending on the bumpiness of the landing, significant demand destruction could pull the rug from under the inflationary drivers.

Structurally, ageing populations and shrinking labour forces should act as a disinflationary force, while increased military spending and rapidly growing government debt would probably be inflationary. On balance, these risks should cancel each other out and therefore, a normalisation appears to be on the horizon.

A quick resolution of inflationary troubles, however, should not be expected and neither can investors afford to be complacent when dealing with inflation in their investment process: As argued in How well anchored are US inflation expectations? expectations have become de-anchored, and it will take more than just a few months of uneventful inflation prints to restore the trust in central banks’ ability (and willingness) to rein in inflation.

Policy rates to stay restrictive

Central bank policy rates are expected to remain in restrictive territory throughout 2023 and, with abating inflationary pressure, be lowered towards the estimates for neutral rates of interest towards the end of the five-year horizon.

The temptation to cut rates significantly as a response to a global slowdown may become large, but wariness of a resurgence in inflation and the high costs of a stop-and-go policy is likely to convince developed market central banks to keep rates in restrictive territory, even during a bumpy landing.

The neutral rates of interest1 for some of the most important central banks are forecast to lie between 2.5-3.0% for the Bank of England, slightly above 2.0% for the US Federal Reserve, between 1.5-2.0% for the European Central Bank and below 1.0% for Swiss National Bank.

Cash rates still below inflation

While most of the macroeconomic outlook has changed compared to two years ago, when we last updated the Capital Market Assumptions, one key characteristic remains in place: cash rates in most currencies are still not expected to compensate for inflation (see chart).

The last period when cash rates outpaced inflation over five years was ended with the global financial crisis and the shift to a regime where inflation was strongly anchored and rates came down. While we might be headed in this direction eventually, the five-year period starting in 2023 should still see negative real cash rates except for the US dollar.

For investors, this is an important reminder that over short investment horizons, of say a few months, cash may be one of the best hiding places from inflationary shocks. But over longer investment horizons holding cash is unlikely to preserve wealth let alone grow it.

Expected real cash returns still mostly negative

CMA macro determinants: 2023-2027 average projections

  Real GDP growth Inflation Policy rate
US 1.4% 2.5% 3.1%
UK 1.1% 3.2% 2.9%
Eurozone 1.1% 2.9% 2.2%
Switzerland 1.3% 1.5% 1.0%
Emerging markets 4.1% 4.5%  

Source: Barclays Private Bank, forecast as of March 2023

Stagflation: a boost to income returns?

With lowered expectations for growth and elevated ones for inflation, most developed economies – especially early in the forecast horizon – will find themselves in a stagflationary environment. The implications of this de-synched macro regime for expected asset class returns can be best understood by breaking down returns into their building blocks: income, growth and valuation.

Along with subpar GDP growth, the growth component is muted. This is reflected in soft earnings growth in equities or roll return in fixed income. The prospects for income returns, on the other hand, depend more on inflation and they receive a boost in the form of dividend and net buyback yields in equities or bond yields. Since fixed income returns generally rely more on the income component, they receive a larger boost than equities in such a macroeconomic environment (see chart).

Barclays CMA return and risk projections

Government bonds: higher returns but smaller diversification benefits

The surge in yields seen in 2022 on the back of central bank rate hikes, and the resulting increased income potential, has boosted the attractiveness of fixed income assets. After their worst year in decades, government bonds seem primed to rival the returns of equities in the early years of the forecast horizon and even surpass equities, in terms of risk-adjusted returns.

Supported by attractive yields, government bonds should return between 2.5% and 6.0% a year on average over the next five years, above the historical average of the last two decades. Beyond five years, returns look like moderating, bringing the ten-year expected returns down to 2.0% to 4.75%.

Government bonds have been important pillars of portfolios, even when the return outlook was less encouraging, due to their negative correlation to riskier assets, especially equities. Last year government bonds failed to provide this diversification effect, with an increased correlation between equities and bonds. Indeed, this effect may be hampered again over the next five years, as inflation still poses a risk (see Is asset allocation at a tipping point). As opposed to primarily growth-driven shocks, inflation-driven shocks tend to hurt both equity and bond investments.

High yield to be caught up in economic slowdown

Investment grade bonds should manage the economic slowdown relatively well and profit, just like government bonds, from elevated yields. European issuers, which face difficult macro conditions, have increased their resilience by adapting their term structure. This is likely to provide a buffer in turbulent periods. Over five years, returns of between 2.5% and 7.0% a year appear possible. Further out, a moderation, like the one in government bonds to between 2.0% and 5.5%, is projected.

High yield and emerging market bonds also profit from the general increase in yield levels. However, with a relatively low number of defaults seen of late and a nearing slowdown, the volatility of high yielding debt is expected to be elevated. Global high yield bonds are forecast to return around 8.2% a year, and hard currency emerging market bonds around 7.1%, over the forecast period. Conversely to government and investment grade bonds, these return expectations are in line with the historical averages over the last two decades.

Equities freed from the burden of high valuations

Equities fell significantly last year and this repricing should come to an end sometime this year, once the bottom in labour markets is reached. Five years out, the outlook is much brighter, as equity valuations are now more reasonably valued. As such, equity returns are predicted to lie between 7.0% and 8.0% a year for developed markets and 10.5% for emerging markets over the forecast period.

Expected equity returns remain close to the averages of the last twenty years except for US equities, which were higher in the past. Compared to the last CMA review, the outlook for equities appears better, as healthier valuations offset the lowered earnings growth estimates.

The fact that equities have lost some of their shine only becomes apparent in comparison with anticipated returns for other asset classes: so-called excess returns (returns in excess of cash rates) for US equities are projected to be 4.0% a year — half the average over the last two decades.

Real assets: pockets of inflation protection

The outlook for private market returns is based on the forecasts for public markets with an illiquidity premium added on top. As such, private equity and private debt projections follow the same logic as their public benchmarks, which leads to expected returns of 10.7% and 9.6% a year, respectively, over the forecast period.

Return projections for directly held real estate over the next five years are 9.8%. One of the appeals of direct real estate to investors is its relatively low correlation to other asset classes. Another reason to invest in direct real estate is its resilience to inflation over the longer term. The illiquidity premia included in these calculations range from 1% for directly held real estate to 3% for private equity.

Commodity returns are projected to be muted over the next five years and expected to deliver 2.5%. Energy prices should plateau this year before gradually falling while prices for industrial metals should support overall commodity returns as economies recover from recession.

Heightened volatility ahead

Turning to volatility expectations, after a tough period for investors with several months of elevated volatility, the news may not get much better soon. In forecasting the outlook for volatility, solely relying on historical estimates seems unlikely to reflect our views regarding the risks of investments.

To address this issue, the historical sample was split into equally sized regimes, called risk-on and risk-off (see chart). The split is based on a statistical measure of the extremity of market moves across all asset classes in scope. This is a richer, and for our purposes, more robust risk gauge than the commonly used VIX index, or fear gauge, which is based on 30-day options on US stocks.

A broader gauge for market risk

Over the next five years, volatility is likely to be heightened due to the increasing likelihood of a bumpy landing and the still heightened levels of inflation. Hence, more weight is attached to the risk-off sample (60%). Further out, there appears to be no reason to overweight either sample, which leads to a balanced estimate for volatility over ten years.

Portfolio implications: focus on core components

The CMA form the basis for our strategic asset allocation. The implications of these risk and return expectations for asset allocation in a portfolio will be discussed in more detail at a later date. From the perspective of risk-adjusted return expectations, it is clear that the attractiveness of fixed income has been boosted when compared with cash and alternatives. As such, striking the right balance between equities and bond investments is even more important.

With regards to volatility, the persisting period of elevated, if slowing, inflationary pressure leaves markets vulnerable to additional shocks. The banking turmoil that hit markets in March is yet another reminder for investors of the attraction of being selective in volatile market environments.


Market Perspectives April 2023

Welcome to our April edition of “Market Perspectives”, the monthly investment strategy update from Barclays Private Bank.