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Equities set to lead returns over the next five years

Lukas Daalder Equities will earn 5.5% annually for investors over the next five years, while returns on German government bonds are forecasted to reach -3%. These are the core predictions of Robeco Investment Solutions’ latest Expected Returns outlook for 2016-2020.

Speed read:
  • We maintain our forecasts for equities rising alongside economic growth 
  • The return of inflation and rising rates will eat into sovereign bond returns 
  • 70% chance of our expected scenario of ‘behind the curve’ normalization 
  • We remain more bullish than bearish as the world continues to recover

What will factor into planning is the return of inflation and the first US rate rise after eight years as the global economy continues to return to normal. The chance of gradual economic normalization continuing following the financial crisis is seen at 70%, though a mix of surprise headwinds may threaten the growing stability.

The return of constraints such as inflation which haven’t been seen for many years – indeed, the bigger threat has been deflation – is termed as a ‘behind the curve’ scenario in which prospects for normal levels growth may be impeded. US inflation is seen peaking at 3% while European price rises should level out at 2.5%.

“We believe that economic normalization is becoming more likely, including the return of inflation and rising interest rates,” says Lukas Daalder, Chief Investment Officer of Robeco Investment Solutions.

“Compared to last year’s outlook we have raised the odds of our central scenario taking place from 60% to 70% at the cost of a reduced likelihood of either a positive or negative adverse scenario from 30% to 20%. It is a logical update from the central scenario presented last year. At that time we expected to see a ‘gradual normalization’ of the world economy, with growth and inflation slowly returning to normal. We still believe this to be the most likely scenario.”

“But as the leading economies in the world have moved closer to the point at which constraints will start to resurface, we have also moved into a more mature economic scenario. This scenario is called ‘behind the curve’. Higher growth, and yes, the return of inflation are the key elements.”

Inflation? Remind us what that was…
Daalder says what may take investors, central bank planners and the wider public most by surprise is the return of something that everyone thought had been abolished – inflation.

‘Higher growth and the return of inflation are the key elements’

“To think that inflation is something that would just simply fall out of the sky once a central bank expands its balance sheet has always struck us as peculiar,” he says. “Inflation is a process of firms raising prices, or labor demanding higher wages; processes which have no direct link with quantitative easing. In the five years to come, strengthening demand will result in economies running into capacity constraints again, which will trigger the re-emergence of inflation.”

“We expect US inflation rates to peak at around 3%, while European inflation will not exceed 2.5%. As such, this ‘behind the curve’ scenario is a logical follow-up to our ‘gradual normalization’ base scenario of last year: we have moved a year further into the recovery phase.”

Asset prices are still pricey
While there are plenty of returns to be had out there, investors should not believe that bull markets will last forever. “ As we stressed last year, most of the asset classes are expensive, which means that we should not get our hopes up that we are heading for strong returns during the next five years,” Daalder warns.

“The most striking element in this year’s forecast is the -3% average annual return we expect for German sovereign bonds. This sounds gruesome for sure. However, it is simply the mathematical result of combining low starting yields with a gradual return of inflation scenario. The very low bond yields offer no protection for the negative price adjustment that we expect.”

It means that equities are once again the preferred asset class in terms on the likely returns. “We expect the price of normalization for equities to be less painful, which is reflected by the fact that we have kept our return estimate unchanged at 5.5%,” says Daalder. “There are a number of forces tugging in opposite directions.”

“On the negative side, we see high valuation, especially in the US, and margin pressures related to rising labor and interest rate costs, pulling potential returns lower. The downside however is capped by the dividend yield of 2.5%, which represents a buffer comparable to that of bond yields, although with a lower guarantee. Additionally, equities will be supported by steady earnings growth, linked to our positive growth outlook.”

To sum up, Daalder says: “We are more bullish than bearish, though the nature of risk and returns will change as the world economy continues to recover. But there are challenges, some of which will be just as disruptive as the unprecedented economic and monetary conditions we have witnessed in the past five years. We remain cautiously optimistic.”
Lukas Daalder

Lukas Daalder

CIO Investment Solutions
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