While the market speculates about the timing of the U.S. Federal Reserve’s next interest rate hike, Fed officials have only confirmed our view that the trajectory of rate increases will remain low. In fact, the Fed is considering other tools for managing monetary policy, with the understanding that persistent low interest rates will limit its ability to use rate cuts as a response to future economic downturns.
In this lower-for-even-longer environment, Northern Trust’s Capital Market Assumptions Working Group believes global equity returns will make slow progress over the next five years. The group’s annual update, released this month, calls for annualized returns in most asset classes that are lower than the outlook last year but still positive, as the global economy is likely to continue its sluggish growth.
So what are the implications for investors? Along with projections for a range of asset classes and geographies, we have identified six key themes to frame our views and help investors understand the forces at work in the economy and the financial markets. Here are the six key themes that we at Northern Trust see shaping the economy for the next five years:
Market cycles in a cycleless economy. Global economic growth is constrained by unfavorable demographics, burdensome regulations and transitioning economies, but many of these same elements are keeping inflation in check, monetary policy easy and the economy ultimately growing. The risk of recession increases as global economic expansion continues, but any economic downturns on the horizon should be shallow, given financial system stability and lack of economic excesses.
Stuck-flation. The combination of ample available supply, sluggish demand and low future inflation expectations may make it difficult for central bankers to dislodge frozen inflation over the next five years.
Costs of ultra-low rates. Central bankers have dug themselves into a zero-rate hole, and they may have no choice but to dig deeper. Despite mounting concern that the benefits of ultra-accommodative policy are failing to offset rising costs, the less risky — and more likely — approach for the near future is more of the same.
Slow-growth angst. Unsatisfactory growth is fueling concern about the future, decreasing consumers’ willingness to spend and leading to political upheaval. This apprehension, in turn, means increasing uncertainty for businesses already hesitant to invest in a slow-growth environment.
Populist roulette. Politicians have seized on the middle class’s growing anger at being left behind, giving rise to populist political movements around the world. These movements are unpredictable — both in terms of how the electorate will vote and what the populist candidates will do if they are put into office. Not all populist-driven policies would hurt economic growth. New fiscal stimulus to counter potential secular stagnation would be welcomed. But the uncertainty surrounding these candidates pressures the outlook for risk-taking.
Technological turbulence. Recent technological advances have the potential to provide strong support for the global economy through increased efficiencies. Government officials, however, may slow technological advancement with policies aimed at protecting jobs. We appreciate the potential of the ongoing tech revolution but do not see it as an unqualified positive for economic growth, given the impediments it may face.
Overall, slower growth and relatively high valuations have moderated our expectations for risk assets. We believe developed-markets equities will return 5.4 percent annually, bookended by emerging-markets equities returns of 7.3 percent at the top end and by U.S. returns of just below 5 percent at the low end.
With our moderate outlook for growth and inflation, we believe interest rates will stay low and fixed income will generate positive returns broadly. We believe the U.S. ten-year Treasury will support a yield of just 1.5 percent in five years’ time, with the yield on the ten-year Bund just 0.5 percent and the ten-year Japanese Government Bond at 0 percent. We believe cash returns will be low to negative, as monetary accommodation is extended.
Although the growth outlook continues to disappoint and expected returns are lower, we still believe a diversified portfolio will handily outpace inflation, which warrants staying fully invested. As always, the most important aspect of portfolio management is the proper alignment of goals with investment assets, ensuring that there is the proper liquidity to ride out the inevitable volatility we will see over the next five years.
Jim McDonald is the chief investment strategist, and Daniel Phillips is a co-manager for the Northern Global Tactical Asset Allocation Fund; both at Northern Trust in Chicago.
