Northern Trust Updates Long-Term Forecasts

Five years is something of an eternity when forecasting equity market risks and returns, but Northern Trust sees reason for optimism in its latest long-term capital markets outlook.

Global growth is likely to endure and mature over the next five years, according to Northern Trust, and the risk of another U.S. or global recession appears to be low. The firm predicts that interest rates will rise only gradually and stocks will return between 7% and 9% over the period. As the report suggests, “the mediocrity of the current expansion increases its expected longevity.” This is in line with recent macroeconomic forecasts from other institutional investors (see “Institutional investors See Fair Weather Ahead”).

Key predictions for the coming economic cycle include a rethinking of emerging market (EM) equities. Northern Trust says tepid demand in developed markets and the maturation of emerging market growth will drive investment managers to treat EM equities “like value rather than growth stocks.” This could be of significant import for investment advisers serving retirement savers, pension funds and other long-term investors looking to control volatility and invest for specific future income goals.

Government regulation has hindered central banks’ efforts to boost the global economy, the report indicates, but output gaps and heightened productivity potential should help keep inflation at manageable levels. A main obstacle to global market growth could be heightened geopolitical risk that shows little sign of abating in the short-term, Northern Trust says.

Violence and political tension may test the decades-long globalization trend, but as Northern Trust suggests, even this risk is relatively low given that global capital markets and globally diversified companies continue to further the case for a global approach to asset allocation. And again, globalized exposure remains a common objective for pension funds and retirement investors hoping to circumvent single-market volatility.

Other potential problems include the expectation that prolonged easy monetary policy and sub-par growth increases the system risk of asset bubbles, Northern Trust says. Speculation continues around potential stock market corrections and ways to efficiently incorporate downside protection into equity portfolios (see “Downside Protection Has a Price”). Regarding fixed-income investments, the search for yield continues, with substantial attention being paid to sovereign debt markets.

Jim McDonald, Northern Trust’s chief investment strategist, says the sub-par growth trajectory since the 2008 global financial crisis has prevented excesses in developed market real economies and required central banks to continue monetary policies that have supported equity market valuations.

"Meanwhile, emerging markets continue to adjust to a maturing growth profile, which weighs on global growth but also reduces inflationary pressures,” he explains.

The main message for investors is that the macro environment will produce slightly lower equity returns and slightly higher fixed-income returns over the next five years, according to the report. The forecast for developed market equities has fallen to reflect the expansion in valuations over the previous 12 months, Northern Trust says, though both margins and valuations are expected to remain above longer-term averages, leading to annualized returns of 7.2%.

Due to the increased demand, emerging market equities will command a premium, with annualized returns of 9%. However, Northern Trust says maturation reduces growth prospects. Fixed-income returns will rise slightly for longer-dated bonds, as the markets price in higher long-term interest rates. Northern Trust's forecasts for short-term rates set by central banks are lower than the market consensus. The continuing search for yield and low default rates will favor credit investments.

Additionally, Northern Trust anticipates real assets will provide protection against unanticipated inflation—global real estate and global listed infrastructure are likely to be the strongest performing asset classes. Private equity and hedge funds will also play important roles in investor portfolios, with the potential to outperform public equities and provide diversified exposure. For retirement plan sponsors and advisers, manager selection is critical when pursuing portfolio alpha.

“The robust returns of recent years have reduced the valuation cushion in asset markets, but while nominal returns will likely lag historic averages, we see real returns of 4% to 5% for global stocks and 1% to 2% for global fixed income over the period,” McDonald continues. "This means that bonds can continue to serve as an important diversifier and source of liquidity while equities and alternative investments provide capital appreciation potential."

In addition to asset class forecasts, the five-year outlook considers key risks and themes to guide investors. For example, the theme "Geopolitical Risk: A Balanced Assessment," notes that recent conflicts have the potential to reintroduce a Cold War-style geopolitical variable and turn back globalization initiatives. However, as conflicts are increasingly handled through the financial system—rather than through military means—the risk of geopolitical escalation is reduced, Northern Trust says.

Other themes in the report include "Emerging Markets: Becoming More Value than Growth," which finds these markets transitioning from a homogeneous high-growth cohort; "The Search for Yield," which predicts the low-rate environment will maintain demand for yield-producing investments, including fixed income and alternative strategies; and "Asset Classes Without Borders," in which asset allocation will focus less on where companies are domiciled and more on where they generates revenues.

A short MarketScape video, featuring McDonald discussing the outlook results, is available online. A full summary of the Northern Trust capital market outlook report is available here.