Beyond the horizon: a five-year capital markets outlook

Using sophisticated macroeconomic and financial forecasting techniques, LGT investment experts came together recently to consider the five-year outlook for capital market returns as part of an annual strategic asset allocation review, updating their estimates for liquid assets (cash, bonds, equities, currencies, commodities and hedge funds) as well as illiquid assets (private equity, private debt and real estate). 

The team developed a trio of scenarios for how the future will play out: a base case representing the most likely outcome, plus a more positive outlook and a more negative one. While predictions always contain an element of uncertainty, the exercise is designed to balance out the sometimes distracting "noise"of the markets day-to-day, and to help optimise client portfolios.

Given the experience of the past two years, with changes in monetary policy and the normalisation of inflation in developed markets, the base case suggests that the returns on equities and bonds will retreat somewhat, but remain decent overall. However, there could still be specific markets or sectors that outperform. Alternative investments, both liquid and illiquid, are likely to drive returns, while also providing welcome portfolio diversification.

The macroeconomic canvas

As in recent years, the global economic landscape will continue to be dominated by the direction of interest rates and growth. While LGT expects lower real growth rates and a slight slowdown in economic activity worldwide over the next five years, the risk of recession has receded, and the expansionary cycle has resumed. Geopolitical risk is expected to persist, though, and this can affect growth rates.

On a more positive note, growth from investment themes such as technological innovation and sustainability could lead to higher-than-expected performance in certain asset classes. Productivity gains due to the adoption of artificial intelligence could come earlier and be even broader than currently expected. The green energy transformation could be another driver, easing uncertainties around climate change, providing a sense of stability in financial markets, and fostering an environment that supports sustained growth.

Fixed income: a sea of change

Central banks seem to have succeeded in containing inflation and preventing macroeconomic uncertainty from rising further. This in turn has set up a new interest-rate regime with neutral rates stabilised at levels below those that were normal before the financial crisis of 2008/2009. By the end of the five-year period, this will be reflected in terminal long-term yields only slightly below current levels.

In a more normalised fixed income environment, investors will need to pick and choose between markets, sectors and geographies to continue to benefit from pockets of return, while continuing to use this asset class as a portfolio diversifier. Money market expected returns are likely to remain above 25-year median forecasts. Credit markets will continue to offer opportunities, with some spreads already close to their fair values.

Equities: sailing through uncertainty

After dipping in 2022, stock markets have started to recover from the inflation surprises of 2023. Cyclically adjusted valuations have increased across developed markets, but payouts have remained stable, meaning that stocks in general are still offering attractive total returns.

The relationship between stocks and real economic growth, however imperfect, offers a good anchor for long-term earnings growth forecasts in most developed markets. This relationship is not as secure in emerging markets, where financial markets are not necessarily aligned with the growth drivers of the underlying economies. 

Alternatives: the path to diversification

In the quest for portfolio diversification, alternative investments stand out as beacons of opportunity. Covering a wide range of sub-sectors from private markets and hedge funds, to commodities and gold, these securities offer the potential for enhanced returns while also acting as diversifiers of traditional equities and fixed income.

LGT expects higher relative performance from many alternative investment sub-sectors over the next five years. Among the risks for alternative investments, especially those in private markets, are that they tend to be less liquid than public markets, and only suited for sophisticated investors. 

Private equity continues to reap an illiquidity premium and to be the source of an additional skill-based premium. So-called cash-plus sub-sectors, like private debt and insurance strategies, offer attractive opportunities. Hedge funds encompass a wide range of strategies that are expected to contribute uncorrelated returns to portfolios, although not all are appropriate for balanced investors.

Looking forward: a vision for the future

Different market environments not only imply different levels of risk and return, but also changes in the correlation between asset classes. Looking at capital market assumptions over the next five years, a more stable global economy, with a normalisation of interest rates and inflation, suggests that correlations between stock markets will remain high. 

Correlations between most government bonds and equities are currently higher than usual. This situation may last for some time, but the correlation remains negative, so government bonds still offer diversification. Alternatives can provide a dose of uncorrelated performance to the mix.

LGT's five-year outlook on capital markets offers a way to look beyond recent market movements and gain insights into the deeper drivers of risk and return in investment markets.    

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