Our five-year forecasts and scenarios: strap up for a two-speed recovery

15 November 2021

By Lukas Gehrig, Zurich Switzerland, Quantitative Strategist; Nikola Vasiljevic, Zurich Switzerland, Head of Quantitative Strategy; Julien Lafargue, London UK, Chief Market Strategist

You’ll find a short briefing below. To read the full article, please select the ‘full article’ tab.

  • Summary
    • We predict an uneven recovery from COVID-19 – with the developed world returning to pre-pandemic levels quicker than developing economies
    • Our capital market assumptions suggest equities will outperform bonds over the next five years
    • With inflation expected to remain elevated into 2022, real assets – like commodities and real estate – are more likely to thrive, going by historical norms
    • Our five-year forecasts also show the value of diversification, across different asset classes and geographical areas, to not only generate returns but also manage risks
  • Full article

    Combined policy responses to the coronavirus pandemic have helped the economy recover, to a point where inflation is already a concern for many investors. Rising prices, and the start of a rate-hiking cycle, favour equities over bonds in our long-term return projections. But with high valuations, a sober breakdown of return drivers is necessary.

    As part of our capital market assumptions (CMA), we provide an outlook for key macroeconomic drivers and the performance of asset classes beyond the typical one-year outlook. Our CMA cover an investment horizon from 2021 to 2026.

    While not denying the difficulty of long-range forecasting, we believe that there are a handful of intertwined themes that can help to structure our thinking about the anatomy of this recovery.

    Recovery at different speeds

    In terms of economic growth, the recovery has played out differently, both with regards to geography and sectors. We believe that this divergence will remain.

    Economies such as the US have experienced aggressive economic and monetary policy stimulus, and are expected to reach their pre-pandemic growth trajectories in 2022. At that stage, the baton will pass from government to private demand sooner than in countries where stimulus has been administered more cautiously.

    In the eurozone, pre-pandemic trend output is expected to be reached in 2023. For many economies where policy responses have been less pronounced, and the path to a full reopening of the economy is more shrouded, the journey to the pre-pandemic growth trajectory could exhaust our CMA horizon (see figure 1).

    Fiscal fast-forwarding

    Past economic cycles have taught us that there is a certain cyclical dynamic in the way gross domestic product (GDP) is distributed1. Typically, companies’ profits shrink at the onset of a crisis, while employee compensation, with nominal wages being sticky, stagnates and thus grows in proportion to profits. While profits rebound over the course of a recovery, wages tend to grow marginally in the years following the trough.

    After the bust of the dot-com bubble, the share of US employee compensation in US GDP, as measured by the US National Accounts, continuously fell until the global financial crisis of 2008-09. Thereafter, the share fell again until 2013, when employee compensation started to grow at a faster pace than firm profits.

    This time around, the same logic does not hold for America: profits surged in the first quarters of the recovery and so did total employee compensation. Compensation encompasses all sources of income, not just wages. Generous unemployment benefits, or furlough schemes, helped to grow the income share of GDP attributed to employees.

    The same difference in crisis anatomy can be observed in the eurozone and the UK: the total income share of both employee compensation and firm profits increased. Public finances paid the bill: tax income less subsidies shrunk significantly. In past recoveries, it would have taken several years until inflationary pressures from wage growth became a hot topic. In this recovery, advanced economies have fast-forwarded through a textbook recovery cycle, price pressures re-emerged only a year after the trough in output (see figure 2).

    Different inflation dynamics

    This fiscal-fast forwarding, and the difference in stimulus application, have strong implications for our inflation outlook. For the US and the UK, we expect central banks to overshoot the inflation target range in the later years of our forecast horizon. Eurozone and Swiss inflation rates, on the other hand, are expected to remain within their respective target range, thus reflecting the reduced risk of overheating in the medium term.

    The ongoing push towards greener economies may well drive up inflation rates in the short-to-medium term, driven by a rush to secure access to natural resources, such as aluminium and copper. In the long term, however, we expect the effect of green transition on inflation to be more muted.

    Return of the Taylor rule

    The speed at which the central banks increase their policy rates, in our projections, is a function of the speed at which economies catch up to the pre-pandemic trend, and the inflation rates they are expected to encounter along the way. In other words, we expect “Taylor rules” to drive our assessment of monetary policy again, and, now more than ever, since the global financial crisis.

    Cash rates to fail compensating for inflation

    One important implication of the current inflation target overshooting, and its more moderated continuation further into our long-term projection, is that, despite interest rate hikes expected in 2022 and 2023, long-term real cash returns are expected to be negative. This continues the struggle of cash as a means of merely preserving value in portfolios.

    To illustrate this struggle, we plot the five-year moving average of real cash returns since 2004 (see figure 3). In the US, just when this metric was about to turn positive, the monetary policy response, and the later surge in inflation, drove real cash returns to an all-time low. But again, the fast-forwarded nature of the recovery should lead to an earlier recovery in real cash returns than observed after the global financial crisis, leading to an average real cash return of close to -1% over our full CMA horizon.

    Macroeconomic methodology

    Our modelling methodology for the macroeconomic determinants revolves around long-term anchors such as historic averages and central bank target ranges as well as the blending of different views with regards to the dynamics towards those long-term anchors. By restricting our look-back period for long-term averages to the year 2000, we acknowledge that structural breaks have made economies from today difficult to compare with their pre-globalisation counterparts.

    By relying on Bloomberg economic consensus data, which aggregates information from almost 70 global banks and blending it with our own expert views, we rely on an extensive body of academic research suggesting that survey-based methods and forecast pooling are a robust and powerful method. See our upcoming methodology whitepaper for more details.

    Building expected return blocks

    Our methodology for estimating expected returns is based on a simple, yet powerful, framework that breaks down expected returns into three complementary building blocks: income, growth and valuation. The returns of listed assets can all be attributed to these three blocks. For non-listed assets, this is complemented with a fourth block capturing illiquidity premia.

    Along with expected return projections, we forecast expected volatilities and correlations. To this end, we have developed a methodology that takes into account the varying behaviour of asset class returns across risk regimes.

    CMA macroeconomic determinants: 2021-2026 average projections
      GDP growth Inflation (%) Policy rate (%)
    US 2.9 2.3 1.3
    UK 2.8 2.1 1.1
    Eurozone 2.3 1.6 -0.3
    Switzerland 2.0 0.7 -0.5
    Emerging markets 4.8 3.8  

    Source: Barclays Private Bank, forecasts as of March 2021

    Fixed income: nominal assets when inflation is rising

    Speaking about building blocks, fixed income returns are primarily a matter of fixed “income” or the expected level of bond yields. Valuation adjustments have considerable effect on returns for shorter investment horizons, as they reflect changes in prices directly. Over a longer horizon, however, moves in yields and prices will offset each other, to some degree. The growth component is estimated from the spot yield curve, and reflects the return of rolling down the yield curve.

    Our expectation for relatively elevated inflation rates, and the start of a hiking cycle, make investing in fixed income a challenging exercise, demanding increasing selectivity.

    High yield and emerging market bonds can support returns in debt, but their relative attractiveness has decreased compared to previous years.

    Government bonds reflect different stages of the hiking cycle

    While we expect the US Federal Reserve and the Bank of England to conclude the rate-hiking cycle, for the policy rate, by 2026, the European Central Bank as well as the Swiss National Bank are far from the end of the cycle by the end of our CMA horizon. These discrepancies drive the differences in the outlook for the income component of our government bond total return projections.

    Credit spreads to remain low

    With increasing issuer risk, spreads over government bonds widen, and so does the income building block while the relative importance of growth and valuation dwindles.

    Current spread levels are low by historical standards, driven by ample liquidity in the market. When, as we expect, this liquidity is gradually drained away, we believe the growth impulse will be enough to keep a lid on these spreads.

    As such, our risk assessment of credit has not changed significantly, limiting the relative attractiveness of riskier fixed income assets compared to government bonds in a portfolio context.

    Equities: up when inflation is elevated

    Breaking down equity returns into building blocks is straightforward: the income component represents dividends and net buyback yields, growth reflects nominal earnings growth, and valuation the expected change in the cyclically-adjusted price-earnings ratio.

    The growth component is modelled by a return to the long-term average earnings growth plus the inflation projection. Given our expectations for above-trend growth paired with a regime of moderately higher inflation, the growth component is the main driver of our equity return projections.

    Equity income has come under pressure lately, but we expect it to slowly revert to its longer-term average, as the recovery evolves and companies face less uncertainty with regards to their cash flows. Valuations should turn into a moderate headwind, as we expect a gradual multiple contraction over the course of the CMA horizon.

    Attractive longer-term outlook for UK equities

    Among developed market equities, UK equities look particularly attractive. This is a function of some catch-up potential in earnings growth in a global recovery, elevated inflation rates and considerably less potential for valuation corrections. The risks for this outlook are predominantly of political nature. A deterioration of the trade relationship with the EU cannot be ruled out, although it is not our base case.

    Real assets thrive with inflation

    Like bonds and equities, returns of commodities can be broken down to income, growth and valuation blocks. Income represents the interest on the collateral, which is approximated by the return on a three-month US Treasury bill in our case, and is – compared to the others - negligible.

    The growth component reflects the shape of the futures curve of the broad commodities aggregate. Growth currently weighs on our projection as the curve is in contango. The most influential component, by far is valuation, and reflects our expectation for future spot prices. Even though prices have increased considerably lately, we believe that commodity prices can go higher. One short-to-medium term driver may be the transition to greener economies, which has the potential to support demand for a number of commodities.

    Real estate falls into two categories in our CMA: publicly-traded real estate investment trusts (REITs) and directly owned real estate. We model REITs just like we would publicly-traded equities. In this regard, REITs provide comparable exposure to our income and growth building blocks, but do not suffer as much from the expected compression in valuations, according to our forecast. Direct real estate is estimated, like its listed counterpart, but with an added premium for illiquidity/complexity.

    US dollar weakness on the back of inflation differential

    Our CMA spans assets from different currency areas. Therefore, we project the four major currencies in the CMA framework: US dollar, euro, sterling and Swiss franc. Our forecasts consist of a view on real exchange rates and expected inflation differentials. The inflation differentials tip the scales against the dollar, in our projections until 2026, leading to moderate weakening against all other CMA currencies.

    Regime-driven estimates of long-term risk

    To estimate long-term volatilities and correlations, we compute risk-on and risk-off covariance matrices. These regimes are typically characterised by relatively low and high volatility, respectively. Our long-term risk parameters are calculated by combining the regime-specific covariance matrices. The mixing weight determines whether the final matrix will be in line with neutral, historical estimates (equal weights) or biased towards the risk-on or risk-off regime (unequal weights).

    In an investment environment characterised by low interest rates, inflation uncertainty, geopolitical risks, and relatively high valuations, we expect to see somewhat elevated volatility in financial markets going forward. Therefore, our long-term risk parameters are estimated by slightly overweighing risk-off regime in our covariance matrix calculations.

    Diversification for the long run

    By putting together our expected long-term return and risk estimates, the key message is that our baseline scenario is anchored by growth expectations over the next five years, however the road ahead might be bumpy at times. Although equities are preferred to fixed income, the risks should not be neglected. In our view, it is necessary – perhaps more than ever – to build a portfolio that is well diversified across a spectrum of asset classes, including alternative investments such as commodities and private markets.

Outlook 2022

Our investment experts look at why active management looks key for equity investors, what elevated inflation and promised rate hikes mean for bonds, our five-year capital market assumptions and the potential opportunities created by climate change that investors need to consider.

Related articles

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

This communication:

  • Has been prepared by Barclays Private Bank and is provided for information purposes only
  • Is not research nor a product of the Barclays Research department. Any views expressed in this communication may differ from those of the Barclays Research department
  • All opinions and estimates are given as of the date of this communication and are subject to change. Barclays Private Bank is not obliged to inform recipients of this communication of any change to such opinions or estimates
  • Is general in nature and does not take into account any specific investment objectives, financial situation or particular needs of any particular person
  • Does not constitute an offer, an invitation or a recommendation to enter into any product or service and does not constitute investment advice, solicitation to buy or sell securities and/or a personal recommendation.  Any entry into any product or service requires Barclays’ subsequent formal agreement which will be subject to internal approvals and execution of binding documents
  • Is confidential and is for the benefit of the recipient. No part of it may be reproduced, distributed or transmitted without the prior written permission of Barclays Private Bank
  • Has not been reviewed or approved by any regulatory authority.

Any past or simulated past performance including back-testing, modelling or scenario analysis, or future projections contained in this communication is no indication as to future performance. No representation is made as to the accuracy of the assumptions made in this communication, or completeness of, any modelling, scenario analysis or back-testing. The value of any investment may also fluctuate as a result of market changes.

Barclays is a full service bank.  In the normal course of offering products and services, Barclays may act in several capacities and simultaneously, giving rise to potential conflicts of interest which may impact the performance of the products.

Where information in this communication has been obtained from third party sources, we believe those sources to be reliable but we do not guarantee the information’s accuracy and you should note that it may be incomplete or condensed.

Neither Barclays nor any of its directors, officers, employees, representatives or agents, accepts any liability whatsoever for any direct, indirect or consequential losses (in contract, tort or otherwise) arising from the use of this communication or its contents or reliance on the information contained herein, except to the extent this would be prohibited by law or regulation. Law or regulation in certain countries may restrict the manner of distribution of this communication and the availability of the products and services, and persons who come into possession of this publication are required to inform themselves of and observe such restrictions.

You have sole responsibility for the management of your tax and legal affairs including making any applicable filings and payments and complying with any applicable laws and regulations. We have not and will not provide you with tax or legal advice and recommend that you obtain independent tax and legal advice tailored to your individual circumstances.