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Investing Specialists

Experts Forecast Stock and Bond Returns: Crisis Edition

Despite fears over a deep recession, lower equity valuations signal higher future stock-market returns, according to our roundup of forecasts from major investment firms.

Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Despite fears over a deep recession, lower equity valuations signal higher future stock-market returns, according to our roundup of forecasts from major investment firms. 

This past January, it was hard to find many major investment firms whose experts were enthusiastic about the prospects for U.S. stocks or bonds over the next decade. Equity valuations were not cheap and bond yields were low. Both factors have historically portended weak returns over the next 10 years. 

Enter the current pandemic. Stocks have slid, though they’ve regained some ground recently and the bifurcation between value and growth names looks more stark than ever. High-quality bond yields have dropped, too. Low-quality bond prices have suffered but their yields have jumped up. 

The question is, does that volatility, combined with broader concerns about economic contraction in the wake of COVID-19, change the outlook among investment providers? Are they more sanguine than they were earlier this year, or does the threat of a sustained recession weigh on their expectations? 

To help answer that, I poked through the capital markets assumptions for the investment providers I included in my early-year compendium. Most firms release their long-term capital-markets assumptions at year-end, but many had updated their return assumptions factoring in recent market weakness. 

How to Use Them
Market return expectations can be most useful when setting expectations, and in turn your plan. While predicting the market’s direction over the short term is difficult and probably folly, you need to plug in some type of long-term return assumption when deciding if your savings rate and time horizon are appropriate given what you’d like to achieve. And if you’re retired, being realistic about return expectations is also essential when determining what’s a sustainable withdrawal rate. 

Before you embed these or any other return forecasts to into your plan, however, it's important to bear in mind that these return estimates are more intermediate-term than they are long. The firms I've included below all prepare capital markets forecasts for the next seven to 10 years, not the next 30. As such, these forecasts will have the most relevance for investors whose time horizons are in that ballpark, or to new retirees who face sequence-of-return risk in the next decade. Investors with very long time horizons of 20 to 30 years or longer can reasonably employ long-term historical returns, but they may want to haircut them a little bit to incorporate what could be a tough next decade.

It's also important to note that the parameters for these return estimates vary a bit; some of the return expectations are inflation-adjusted while others are not (nominal). In addition, some of the experts forecast returns for the next decade, while others employ slightly shorter time horizons. The firms also vary in their approaches to formulating the forecasts, though most rely on some combination of valuations, current yields, and earnings growth and inflation expectations to arrive at return expectations. Finally, it’s worth noting that the market is moving fast, so expect these forecasts to be pretty ephemeral, too. 

BlackRock Investment Institute 
Highlights: Higher return expectations for developed- and emerging-markets equities and corporate credit; lower return expectations for government bonds (March 10, 2020).

BlackRock Investment Institute hasn’t yet released full asset return expectations that incorporate the COVID-19 pandemic and its effect on equity valuations and bond yields. However, a white paper that the institute released in March noted that the recent market shock had boosted its five-year outlook for equities, both developed-markets and emerging, through March 10, relative to its outlook released at the end of 2019. (Back in December, the firm’s forecast was for a 4.5% annualized [nominal] mean expected return for U.S. large caps over the next five years, 5.2% for European equities, and 5.8% for emerging markets.) The report’s authors wrote, “We see a strategic opportunity emerging to allocate more to equities given the repricing that has occurred, underpinned by our belief that the coronavirus impact is different to the financial crisis. Many portfolios will have drifted from their target asset allocation.”

Not surprisingly, given higher yields and the beating that corporate credit took during the March 2020 market sell-off, the firm had also boosted its outlook for corporate credits as of March 10. “The case for credit is also stronger yet more nuanced,” the report’s authors wrote. “Valuations are clearly cheaper now, creating opportunities for investors, but late-cycle risks such as higher defaults, particularly in the high-yield market, cannot be ignored.” At the same time, the report’s authors argue that government bonds are even less attractive at current yields when they were at the outset of 2020.

Grantham Mayo Van Otterloo (GMO) 
Highlights: Negative 1.5% real (inflation-adjusted) returns for U.S. large caps over the next seven years; negative 3.8% real returns for U.S. bonds; 4.9% real returns for emerging-markets equities; 3% real returns for emerging-markets debt (March 31, 2020).

GMO is a valuation-conscious firm, so it’s no surprise that the market sell-off in the first quarter of 2020 caused it to increase its return expectations for equities, notwithstanding the deep uncertainty about the economy’s current trajectory. That said, the firm’s expectations for U.S. stocks are still far from rosy; its seven-year forecast calls for a 1.5% loss for U.S. equities on an inflation-adjusted basis. Still, that’s better than the 4.4% annualized real loss the firm was projecting for U.S. large caps at the end of 2019. As in the past, the firm is more sanguine about other subsets of the equity market: It’s expecting small but positive real returns for U.S. small caps and international developed markets equities over the next seven years, and better returns still for international small-cap stocks and emerging-markets stocks (3.7% and 4.9%, respectively, on a real basis). As in the past, the firm is most optimistic about the prospects for value-oriented emerging-markets equities, forecasting a nearly 12% annualized real return for the category over the next seven years. 

At the end of 2019, GMO was pessimistic about the prospect for U.S. bonds and the firm grew even more cautious in the first quarter: It’s expecting an annualized loss of 3.8% over the next seven years for U.S. bonds and a 4.3% loss for hedged international bonds. Emerging-markets debt is the sole fixed-income category that the firm evinces any enthusiasm for: It’s projecting a 3% real annualized return over the next seven years.

Morningstar Investment Management
(return assumptions released in Morningstar Markets Observer; latest issue with new data due out in late April 2020)
Highlights: 4.6% 10-year nominal returns for U.S. stocks; 1.6% 10-year nominal returns for U.S. bonds (March 31, 2020).

At the end of 2019, Morningstar Investment Management’s team was expecting a weak showing from U.S. stocks over the next decade--just 1.7% nominally. But the COVID-19-related market shock has driven valuations to more attractive levels, prompting it to boost its equity return expectation by nearly 3 percentage points, to 4.6% nominally on an annualized basis over the next decade. As was the case at the end of 2019, MIM is more optimistic in its outlook for developed non-U.S. and emerging-markets equities, forecasting returns of nearly 10% on a nominal basis over the next decade. 

In line with other firms in our survey, MIM’s expected 10-year return for high-quality fixed-income assets dropped along with yields in the first quarter, from 2.1% at year-end 2019 to 1.6% at the end of March. However, its return expectation for junk bonds shot up to 7%, an increase of 3 percentage points since year-end 2019. 

 

Research Affiliates 
Highlights: 1.5% real returns for U.S. large caps during the next 10 years; negative 1.0% real returns for the Aggregate Index (March 31, 2020; valuation-dependent model).

Research Affiliates’ easy-to-use scatterplot of expected returns over various time horizons is updated monthly, so its return expectations are always quite current. As with the other firms, RA’s return expectation for U.S. equities lifted a bit after the first-quarter market rout, to 1.5% real returns for U.S. large caps over the next decade, up from just 0.3% at the end of 2019. That’s pretty underwhelming, but the firm’s return expectation for non U.S. names is substantially more robust: The valuation-dependent model is forecasting 7.3% real returns for the MSCI EAFE (developed markets index) over the next decade, and 9.3% real returns for emerging-markets equities. 

Research Affiliates isn’t expecting much from U.S. high-quality fixed-income over the next decade. The firm is forecasting a negative 1% annualized real loss from the U.S. Aggregate index and a stunning 4.7% annualized loss from U.S. long-term Treasuries over the next decade. It’s more optimistic in its outlook for risky fixed-income assets, forecasting a 2.9% real return for U.S. high-yield, a 3.4% real return for bank loans, and a 4.8% return for emerging-markets bonds denominated in local currencies. 

Vanguard
Highlights: Nominal U.S. equity-market returns in the 4.8% to 7.8% range during the next decade; 8.3% to 11.3% returns for non-U.S. equities (for U.S. investors); 1% to 2% expected returns for U.S. fixed income (March 12, 2020).

In a recent update to its Economic and Market outlook released at the end of 2019, Vanguard indicated that lower valuations due to the COVID-19 pandemic had prompted it to lift its equity-return forecasts. Whereas the firm was forecasting 10-year returns in the 3.5%-5.5% range as of year-end 2019, the latest forecast is for 4.8%-7.8% U.S. equity returns and even better returns (8.3%-11.3%) from non-U.S. equities. (Vanguard expresses its return expectations in a range.) 

Like all of the other firms in our survey, Vanguard’s return estimate for high-quality fixed income dropped along with yields. Its expectation for U.S. bonds dropped to 1%-2% from 2% to 3% in December; its outlook for non-U.S. bonds and U.S. Treasuries is even more pessimistic.