The primary driver of slowing US and global real GDP growth is a decline in working-age population growth.
As growth slows, costs are rising amid higher inflation.
Notably, the labour share of income is climbing higher after a multi-decade trend lower, and companies are seeing lower net profit margins. A higher cost of capital is also likely to act as a restraint on profitability and earnings growth.
At the same time, a higher required risk premium will also likely drive down equity multiples.
In other words, higher rates mean that investors can achieve higher yields with lower risk in fixed income, making risk assets, notably equities, relatively less attractive.
That is particularly true for US equities, where our assumption is for annualised returns of 7.3 per cent over the next 10 years.
These returns are only slightly above our assumption for emerging markets (7.2 per cent) and are lower than that for developed international markets (7.7 per cent); in these markets, valuations are relatively lower now and do not need to adjust down, unlike valuations in US equities.
Expected returns stand in stark contrast to the prior decade, when US equities outperformed emerging and developed international markets substantially.
Implications for real assets
The new market regime is driving higher expected returns for real assets.
Higher production costs, increased regulation, a scarcity of resources, and recent underinvestment will drive returns in natural resource equities and commodities over the next 10 years.
At the same time, resource producers have faced revenue pressures for years and have instilled greater supply-side discipline and a greater focus on profitability. Better growth and higher profitability also support valuations of resource equities.
Higher expected returns for commodities, as measured by the Bloomberg Commodity Index, are also driven by higher production and extraction costs, which are the result of inflation, as well as by a longer-term shift as we move from a period of oversupply to one of undersupply.
Higher expected collateral returns (in light of higher expected interest rates) will also contribute to commodity total returns.
We also expect infrastructure to perform well given predictable cash flows and the fact that many infrastructure sub-sectors – such as airports, marine ports, midstream energy, toll roads and towers – have revenues that adjust with inflation.
Indeed, infrastructure has historically produced above-average returns when inflation has been high but moderating.
We also expect investor demand for infrastructure to remain high, as the asset class generally has lower volatility than the broader stock market due to its relative earnings stability.
In the expected higher inflation/lower growth environment, we believe that REIT cash flows will remain resilient and that constrained new supply will benefit real estate prices, though lower economic growth could be a modest headwind.
