- Elevated valuations, rising inflation, and more restrictive central bank policy suggest lower-than-average forward long-term return assumptions in our base case for all US asset classes.
- We believe US stocks still have better return potential than bonds, but stock returns are lower than our forecasts from last year.
- International stocks, with a sector composition better suited for a higher inflation environment, continue to have better potential long-term returns versus US, in our view.
- Intensifying geopolitical conflicts between the US and its rivals cause us to downgrade long-term return potential in Emerging Markets.
At RiverFront, we believe in ‘process over prediction’. This is the idea that a dynamic investment process built to adapt to unexpected events is more important to long-term investment success than anchoring on any particular forecast. Nonetheless, we view long-term (5-to-7 year) capital market forecasts as a useful part of our process to help identify and monitor what we think are important long-range drivers for markets.
Today we deliver an update to the April 2021 capital market assumptions with an emphasis on what has changed in the macroeconomy and in our forecasts over the last 12 months.
The Pros and Cons of a Reflationary Cycle on Future Returns
A lot has happened since our last long-range forecast was published almost a year ago. COVID-19 remains a tragic facet of daily life but is now less deadly in the developed world due to widespread vaccination and exposure. In addition, effective anti-viral treatments are predicted to be widely available by spring of 2022. The US jobs market has dramatically improved and corporate earnings across the world have come roaring back. Despite all that good news, stock and bond markets have seen mixed returns since our last update, with a stellar 2021 offset by a rough start to 2022.
We believe a big part of the recent weakness in both stocks and bonds is the bad news that accompanies all this good news - global central bank policy, led by the US Federal Reserve (Fed), is starting to turn more restrictive in response to developed world inflation prints not seen since the early 1980s. (see Chart 1, below). In the April 2021 Strategic View, we stated “the current bull market in stocks is based on a foundation of very low interest rates and contained inflation expectations.” That foundation is currently being tested, as the US Fed futures market is currently pricing in six interest rate hikes in 2022; a dramatic rise from just a few months prior and much higher than we assumed in forecasts last year (See Chart 2, below).
We believe that the recent inflation spike is mostly related to pandemic-influenced supply-chain issues, and more recently, by geopolitical issues in central Europe. Thus, as the world adapts to living with COVID-19 and with an increasingly belligerent Russia, we expect some of these pressures to subside, allowing our inflation forecasts to moderate further out in our 5-to-7-year forecast horizon. However, we acknowledge that labor shortages and a potential mindset shift around prices may persist, and that higher inflation this early in the new economic cycle has changed the reaction function at the Fed in ways that may further challenge stock market valuations. This fact has prompted us to lower our long-term return ‘Base’ case forecasts for both long-term US stock and bond returns from last year’s forecasts. For stocks, the increased valuation contraction caused by higher interest rates could more than offset the increased corporate earnings and cash flows generated by the reflationary macro backdrop.
Summary: 2022 Long-Term Equity Capital Market Assumptions
We believe these higher-than-expected interest rates will also further impair the already poor long-term return potential we see for US government bonds. The path dependent nature of yields on fixed-income total returns are crucial to long-term forecasting. The quicker rates rise, the more near-term pain is felt in bond prices…but we believe the long-term investor has more time in which to reinvest and compound higher coupons, which can lead to improved returns for patient investors. Therefore, in each of our three scenarios, we assume different speeds of interest rate normalization, with our Base case assuming that the US 10-year treasury yield ‘normalizes’ to our terminal 4.0% forecasted yield a little more than two-thirds of the way through our roughly 7-year forecast horizon. In the Bull case for bonds (which corresponds to our Bear case for stocks), we believe the terminal rate is higher at 4.5% and reaches this level more quickly as inflation continues to force the Fed’s hand to hike rates faster, allowing higher coupon payments to accrue longer (see Fixed Income Forecasts section for more details).
International equities, with a more cyclical, value-oriented sector composition than the US – including greater weighting to energy, materials, and financials – may be better suited for a higher inflation environment going forward, in our view. In addition, we believe international historical valuations are less elevated relative to the US, suggesting less valuation pressure going forward. Thus, in our long-term forecasts, we continue to assign higher potential long-term returns to developed international indices vs. US indices. Asset allocators across various time horizons must weigh developed international’s long-term valuation advantage against its’ more compromised economic fundamentals relative to the US. Like developed international, we also view emerging market stock valuation relative to US stocks to be favorable for long-term returns vs. the US. However, deepening and intensifying geopolitical conflicts between the US and its non-democratic rivals cause us to downgrade long-term return potential in emerging markets relative to our forecasts from last year (see Global Equity Forecasts section for more details).
While our broad asset class forecasts haven’t changed dramatically from 2021 in absolute terms, we do think the shift to higher structural inflation for the foreseeable future will have a significant impact on security selection within these asset classes. More specifically, we believe the stocks of industries levered to higher interest rates and the macroeconomy have a strong chance of multi-year outperformance. Thus, we have chosen to dedicate a section of this piece to exploring our views into US sectors (see 2022 Special section for more details).
2022 GLOBAL EQUITY FORECASTS: Inflation, ‘Slow to Overreact’, Is Now a Major Factor in Forecasting the Future
As we stated last year, the current global bull market in stocks for the past decade has been based on a foundation of low interest rates and contained inflation expectations. Investors with a longer time horizon have had little choice but to buy stocks or live with the low returns from cash and bonds. Since the ‘Great Recession’ of 2008, the world’s central banks have tried to boost aggregate demand with aggressive monetary policy; lowering short-term interest rates to zero and then buying longer-term bonds to drive long rates down as well. This has certainly helped the prices of stocks, bonds, and real estate… but hadn’t until recently generated above-average inflation.
However, the supply chain issues surrounding the COVID-19 pandemic and recent geopolitical issues in Eastern Europe have changed the trend of inflation dramatically, and the Fed, judging by their recent comments, have taken notice. The major change from last year is today’s inflation regime, which has been trending near levels not seen since the early 1980s (see Chart 1, below).
Chart 1: Consumer Inflation Currently at Early 1980s Levels
Since last fall, the Fed has embarked on a dramatic change in tone around the path of rate hikes, as can be seen in the embedded path of the Federal Funds (Fed Funds) futures market currently, versus at certain times in the near-term past. While the Fed Funds futures market is not a reliable forecaster of future rates in our view, we believe it is an accurate reflection of what investors are currently pricing in for future rate hikes. By this rubric, investors believe that the Fed’s target rate will be over 2.0% by 2024-a dramatic change from the market’s embedded view just 3 to 6 months ago (see Chart 2, below) and a significantly higher rate than we were expecting when developing our forecasts last year. We also would note that the level of recent volatility seen in this data is higher than we can ever remember, reflecting the high degree of uncertainty investors feel.
Chart 2: ECBOT-30 Day Fed Funds March 2022
Current price-to-earnings multiples on US stocks, while lower than to start the year, remain elevated relative to history (see Chart 3, below), and the current reading of trailing twelve-month earnings-per-share is also well-above long-term trend levels (see Chart 4, below). Both conditions suggest to us that valuations will likely compress in the future. Thus, all three of our scenarios assume that terminal multiples shrink at the end of our forecast period as a function of higher interest rates. However, we believe the reason that rates rise matters. If rates rise over time primarily due to improved economic growth, corporate earnings can outpace valuation contraction and stocks can do well. On the other hand, if economic growth stagnates, earnings may not grow enough to offset falling valuations and stocks may struggle. How far rates will ultimate rise in this cycle will also have a major effect on stock prices. In our various scenarios for 2022, the terminal (ending) 10-year treasury yield ends up between 3.5-4.5% but averages 3% or lower over much of the 7-year horizon in our Base and Bull cases. In our Bear case, inflation stubbornly averages 4% with below-trend economic growth, causing rates to spike earlier in the horizon before dropping with the onset of US recession. This dynamic would cause valuation multiples on US stocks to meaningfully drop below current levels, in our view.
Chart 3: S&P 500 Forward P/E Range
Chart 4: S&P 500 Trailing 12-Month Earnings-Per-Share
Base Case Equity Assumptions:
- US VALUATION: For the US, we assume ~2.5%/year contraction in P/E multiple, as core inflation averages close to long-term average of 3% and Fed remains in rate hike mode; terminal P/E ratio at end of cycle is ~16.5x.
- US EARNINGS GROWTH: Assuming ~6% corporate earnings growth, based on slightly better than trend-like economic growth; reflationary backdrop leads US and rest of the world to reasonably strong Gross Domestic Product (GDP) growth over the next few years. We are assuming little structural reform and slightly lower profit margins and a slightly higher tax regime vs. the current environment.
- For Developed International Markets, we assume 14.5x multiple for Europe and 13.5x for Japan, which represents no meaningful expansion or contraction from current levels for either geography; assuming Earnings per Share (EPS) growth of 4% in both Europe and Japan respectively.
- For Emerging Markets, we assume 12x terminal P/E multiple (no expansion or contraction from current) and ~4% EPS growth – both historically low - due to structural slowing in Chinese economic growth as well as further economic losses related to heightened geopolitical tensions between China and Russia vs. the West.
Bull Case Assumptions:
For the US we are assuming a 17x forward P/E terminal multiple, which would represent an average contraction of -2.0%/year through the next cycle; this is assuming earnings growth of 9%, contained inflation averaging 2.5%/year, a 3.5% terminal US 10-year treasury yield, flat to slightly higher profit margins from current, and a flat to slightly positive US dollar. From today’s starting point this may seem optimistic. However, it bears noting that the S&P 500 has averaged corporate earnings growth of close to 10% over the past five years (source: Refinitiv Datastream), so this level of growth would only mean the US returning to something resembling a recent historical rate. For Europe we are applying a 14.5x multiple - close to today’s levels - with 7% earnings growth. In Japan, we also assign a 14.5x multiple on 8% growth in earnings, assuming some profitability benefit due to improved corporate governance and efficiencies. For emerging markets, a ‘dare to dream’ outcome would include slight multiple expansion from current levels and 6.5% earnings growth, as economic growth in commodity-producing areas and India more than offset economic losses from China’s reversal away from Western integration.
Bear Case Assumptions:
Multiples shrink meaningfully across all geographies as the pernicious combination of higher structural inflation and lower economic growth pervade the globe. For US markets, our assumption includes a 16x terminal multiple on earnings and earnings growth of less than half historical averages at around 3%, compounded by higher taxes, lower profit margins and a relatively weak US dollar. In Europe, Japan and Emerging Markets, the lower structural efficiency and higher funding costs and labor rigidity inherent in those economies means less ability to pass along inflationary pressures, resulting in lower earnings growth than in the US. Under this ‘grey-sky’ scenario, we are also forecasting contracting valuations in international regions even from the relatively modest valuations of today, due to the mixture of higher inflation and lower economic growth.
2022 SPECIAL SECTION: Long-Term Sector Implications of a Reflationary, Higher Interest Rate Environment
As we consider the impact of potentially heightened inflation and interest rates over the coming years, we wanted to look at how some of the different scenarios we envisage might affect earnings and returns for different sectors. To do so, we utilized not only our proprietary discounted cash flow (DCF) modeling but also our team’s qualitative sector methodology. For our discussion, we selected themes to compare and contrast where either the business model or its response to one of our major economic variables were sufficiently diverse as to merit further exploration. While no market cycle is ever predictable, our hope is to be able to manage portfolio risks by identifying the effects of surprises on long term financial results. We believe focusing intently on sector allocation and stock selection will be critical to our ability to successfully implement our macro views in the coming years, whichever of our scenarios proves to be correct.
Utilities vs Financials: Financials Better Poised to Benefit from Inflation & Interest Rate Volatility
Utilities are largely regulated in the US, and among the most heavily leveraged companies in the S&P 500. This puts them in a tough position whenever interest rates rise, as it can damage their profit margins. Inflation will also prove a challenge with utilities; while all companies struggle with passing on rising costs to consumers to some extent, utilities are required to essentially seek permission from state regulators, many of whom face political pressures from their constituents. This means utility revenue rates are likely to lag rising inflation, in our opinion. We believe the net effect is that utilities are one of the least desirable sectors over the next few years, although they are still more attractive as a total return instrument than investment grade fixed income in our Base case.
Financials and Real Estate Investment Trusts (REITs), on the other hand, benefit from interest rate increases and inflation in several ways. Banks will typically benefit from an increase in the longer-term interest rates that they use to price loans, as this can increase their ‘net interest margin’. Additionally, rising inflation typically implies rising nominal economic growth, which tends to be supportive of loan portfolio growth. Rising inflation can also lessen the likelihood of loan default, as technically the loan liability is less onerous to the borrower due to it being worth ‘less’ in inflated dollars. Insurance companies can also benefit by rising inflation and rates, especially in their portfolios that they use to hedge claims. These portfolios are typically invested in short term securities that would benefit greatly from a liftoff from zero interest rates. And lastly, REITs, like utilities, are major consumers of credit; the carrying costs of credit can become more expensive as rates rise. However, REITs can raise prices relatively quickly to offset higher credit costs, unlike utilities - especially in shorter lease property types. While that option might not yet exist for office, shopping center or hotel REITs, those also stand to gain from improved occupancy. For all these reasons, we believe that Financials and REITs will perform better than utilities as rates rise. Accordingly, in all our macroeconomic scenarios, we prefer Financials over Utilities across our portfolios.
Staples vs. Technology: Changing Growth Expectations and Different Cost Pressures Favor Tech as a ‘Growth’ Play
Consumer Staples (Staples) have performed well in the low-interest rate, low-inflation world that has existed since the 2008 Financial Crisis. While these businesses tend to have relatively low profit margins, the decade-long advent of low inflation, combined with effective cost management and buybacks of equity using low interest rates, has enabled many staples companies to cobble together impressive profits and stock market returns. While we believe they will continue to be able to grow revenue in nominal terms in all our scenarios, our belief going forward is that rising interest rates will likely put a dent in profit margins and decrease staples’ ability to buy back shares, reversing these secular tailwinds for the sector. And while some sub-sectors will have pricing power, staples in general continue to face new entrants as health and eating trends shift. Additionally, higher structural inflation will place pressure on input costs and wages that may limit the benefit of price increases that staples are able to pass onto consumers. Staples are also still working through excess valuations from COVID-19 spending habits that we think will likely revert to pre-COVID-19 levels over time. We believe that many of these well-run Staples companies will disappoint shareholders in the years ahead.
A better place to seek growth at a reasonable price, in our view, is in Technology. While inflation will raise component costs for semiconductors and hardware manufacturers and labor shortages will raise costs of labor, large technology companies should be able to offset these costs due to a handful of smart decisions they have made over the past few years. First, platform-based solutions coupled with monthly subscriptions instead of one-time purchases have enabled large tech companies to expand their reach broader and deeper into enterprises and monetize relationships more effectively. The higher-margin nature of technology – in general an ’asset-light’ business model - allows for cost absorption and the ability to pivot easier than lower-margin ‘asset-heavy’ businesses. Second, the comparatively low amount of leverage and high credit ratings companies enjoy in this space will allow them to continue to use debt for buybacks and investment, while maintaining lower costs of capital. For all these reasons, we prefer Technology to Staples as a growth play through the next business cycle, across multiple scenarios.
Energy vs. Industrials: Both Attractive Long-Term to Us, but High Inflation Benefits Energy to a Greater Extent
Inflation is expected to hit every major part of a corporation’s income statement, often in multiple, nuanced ways. Thus, a nuanced look at some of the effects of high inflation can help draw contrasts between two sectors, such as industrials and energy, that seem to largely follow the same broad economic heartbeat. While both will undoubtedly benefit from higher inflation and the nominal growth inflation will likely accompany, the journey of a dollar of revenue down the income statement for energy companies is likely to be more rewarding than an industrial one for several reasons. First, commodities are a major driver of inflation, and commodities are generally a much larger input cost to industrial companies than energy companies. So, while revenue will likely grow for both sectors, our belief is that energy will broadly enjoy faster operating earnings growth than industrials during this period.
As we move from the net income to the cash flow statement, a second advantage emerges for the energy sector: years of low commodity prices have created historical cash flow headwinds for energy credit issuers. Our belief is that higher oil prices – a likely driver of inflation - will have the benefit of increasing financial stability in energy companies, possibly improving credit ratings and driving down loan default rates. All of this will also likely benefit industrials as well, but we believe energy companies are uniquely poised to generate outsized returns, should inflation and oil prices stay elevated for the foreseeable future. We prefer both Energy and Industrials to most defensive and growth sectors for the business cycle ahead, and we believe it is also important to have a diversified approach.
2022 Fixed Income Forecasts: Inflation Holds the Key to our Long-Range Scenarios
The path of interest rates over the next seven years is unknown. However, we know that the path of interest rates will influence fixed income returns. Given the uncertainty of the path of interest rates over the next seven years, we have chosen to create three fixed income return forecasts: a Bear case, a Base case, and Bull case. We started by focusing on the Bloomberg Aggregate Bond Index (Aggregate) by forecasting yields for the following components of the index: Treasuries, agencies, mortgage-backed securities, and corporate bonds, as well as the index itself. This approach allowed us to reconcile the index forecast with a bottoms-up sector forecast. We made several assumptions to generate the forecast for the Aggregate total return approximately seven years forward. First, we assumed that the 10-year Treasury yield would be representative of the Aggregate’s yield. Next, the Aggregate’s current yield and duration were used to calculate future price changes. Lastly, the terminal rate was used to calculate income. Using this structure, the three forecasts were generated for the Aggregate seven years hence.
Base Case Fixed Income Assumptions
Under the Base case scenario, bond investors receive a 1.51% per annum and the terminal rate on the 10-year Treasury is 4%. We assume that investors experience 154 basis point increase in yield over the current yield of the Aggregate over seven years. In the base case, the path to reach 4% is enhanced as investors would receive sixty-eight percent of the increase at the onset of the seven-year period allowing for larger coupon payments to be reinvested over the horizon.
Bull Case Assumptions
Under the Bull case scenario, bond investors receive a 2.66% per annum and the terminal rate on the 10-year Treasury is 4.5%. We assume that investors experience 204 basis point increase in yield over the current yield of the Aggregate over seven years. In the Base case, the path to reach 4.5% is enhanced as investors would receive ninety percent of the increase at the onset of the seven-year period allowing for larger coupon payments to be reinvested over the horizon.
Bear Case Assumptions
Under the Bear case scenario, bond investors receive a 0.87% per annum and the terminal rate on the 10-year Treasury is 3.50%. We assume that investors experience 104 basis point increase in yield over the current yield of the Aggregate over seven years. However, the path to reach 3.50% is not linear and investors would only get fifty percent of the increase at the onset of the seven-year period which impacts the investors’ overall return experience because they have less time to reinvest coupon payments to enhance the income.
The low interest rate environment experienced since the financial crisis of 2008 is set to be recalibrated as the Fed attempts to normalize rates. We believe this recalibration will have an impact on yields and ultimately the total return of bond portfolios. While price depreciation is to be expected in a rising interest rate environment, the income can be greatly impacted by the path of interest rates. As witnessed by our seven-year forecasts for the Aggregate, the faster and more dramatic the repricing the better expected returns on bonds will be in the future, offset by worse equity returns. Balancing all these factors we believe that the Aggregate will yield 4% and return 1.51% per annum.
We believe the following disciplines will be crucial to deploy for asset allocators given the current backdrop:
- Dynamic Asset Allocation: The flexibility to move up and down asset allocations quickly as the fundamental backdrop changes.
- Active Risk Management: Deal with potential increases in stock and bond volatility.
- Ability To Incorporate Alternatives: The willingness and ability to seek alternative sources of return and income.
- ‘Process over Prediction’: The willingness to shift strategies in a calm and disciplined way as unexpected events change.
- Transparency and Communication: Emotional alpha will be maximized in an environment where the investor and asset manager are in a healthy relationship of trust and two-way communication.
At RiverFront, we are facing this challenge clear-eyed and calm. While we believe building prediction engines are important, we also believe building an unemotional, adaptable discipline that is consistently applied gives investors the best chance of long-term success.