Capital Market Expectations: Higher yields lift all boats

Preview

Every year we review the data that drive capital markets—current valuation measures, historical risk premia, economic growth and inflation prospects—to provide the foundation for our forecasts. We update the models that we use and review their continued appropriateness. Crucially, our models are based on first-principle economic relationships and reflect seasoned practitioner judgment.

We continue to include as part of every capital market forecast a measure of the expected volatility of that asset class, informed by long-term observed standard deviation of returns. Given that changes to global central banks’ quantitative easing policies may have repressed both equity and bond market volatility over past years, but increased turbulence more recently, our approach to modeling volatility reduces recency bias and is particularly appropriate at a time when many leading central banks have moved to normalized policy.

Our  (CMEs) are designed to provide annualized return expectations over a longer-term horizon, typically viewed as 10 years. Specifically, we calculate geometric mean return expectations over a 10-year period, which both fully captures the average length of a US business cycle and aligns with the strategic planning horizon of many institutional investors.¹

Our modeling approach is based on a blend of objective inputs, quantitative analysis and fundamental research, consistent with the skill set of our Franklin Templeton Investment Solutions (FTIS) business. Underpinning these inputs are assumptions on the sustained growth rates that developed and emerging economies can expect to achieve and the level of price inflation they will likely experience. This approach is forward-looking, rather than being based on historical average returns. This is especially important in an evolving macroeconomic environment.

Summary

We believe riskier assets, such as global stocks and corporate bonds, have greater performance potential than global government bonds, despite slightly slower global growth and supported by a marginal decline in global inflation expectations.

• We believe that maintaining a diversified portfolio of risk premia, in addition to the traditional benefits of a balanced portfolio between stocks and bonds, is the most likely path toward stable potential returns.
• With global interest rates starting from elevated levels and expected to normalize, overall return expectations from all fixed income assets have become significantly more attractive to us than has been the case in recent years, and notably higher than we anticipated in our 2023 CME forecasts.
• The risk premium contained within corporate bond yields has tightened but appears to be adequate compensation for the likely level of default risk across the business cycle.
• Earnings growth and yield will likely drive equity returns, with minor support from some valuation uplift. We no longer expect margins to be a headwind over our 10-year horizon.
• Over the 10-year horizon used for our CMEs, we see relatively healthy alternative risk premia and a constructive environment for asset returns.
• We expect the US dollar to depreciate versus most currencies as our valuation metrics suggest it is overvalued.