Rethink Capital Market Assumptions

Our annual publication ‘Rethink Capital Market Assumptions’ sets out in detail our return and volatility expectations, by asset class, for the decade ahead. Our analysis reflects our underlying macroeconomic forecasts, from inflation and interest rates to growth.

Amid questions on the impact of artificial intelligence on global economic productivity, demographic shifts across regions, persistent geopolitical fragmentation, and a rewiring of global trade and financial ties, our annual review of structural macroeconomic assumptions and their implications for major asset classes takes on heightened significance.

The phrase “borrowing from the future" captures the recent sustained outperformance of multi-asset strategies, driven largely by US economic exceptionalism. We maintain a positive outlook for financial assets over the next decade. Nevertheless, the accelerating AI race between the US and China, with the latter rapidly narrowing the technological gap and leveraging cost advantages, now sets the stage for a broadening of equity performance across regions, with emerging markets particularly well positioned.

In portfolios, as efficient frontiers flatten, further diversification remains imperative. After last year's depreciation, the dollar looks less overvalued; while it could weaken in a more fragmented world, we do not anticipate a debasement.

In portfolios, further diversification remains imperative

Three expectations are key to constructing portfolios for the decade ahead: structurally higher interest rates, the broader distribution of returns across assets and regions, and a cyclical weakening of the US dollar. Altogether, these set the stage for broader diversification than before

Long-term macroeconomic outlook – a tug of war between AI and demographics

Underpinning our capital market assumptions are key macroeconomic variables such as potential growth, the inflation regime, and the neutral rate of interest – i.e. the rate that neither drives nor constrains growth. We have slightly revised our potential growth estimates upwards to reflect positive AI impacts, although this productivity increase is tempered by adverse demographics and some negative short-term US policy effects.

Potential growth can be defined as the rate at which an economy can grow sustainably over the long run without generating inflationary pressures. As with most macro variables, an economy’s potential growth is not directly observable. To estimate it, we look at its fundamental drivers – namely, demographics and productivity.

Currently, all major advanced economies are seeing a fall in working-age population ratios. China has now joined other ageing societies in this trend. Since an economy’s potential growth is determined by the size and the productivity of its labour force, a shrinking labour force will translate into lower potential growth, unless there is a significant pick-up from offsetting productivity growth.

A shrinking labour force will translate into lower potential growth unless there is a significant pick-up from offsetting productivity growth

For more on how we are capturing the investment opportunities that flow from fundamental transformations in our economies and societies read our publication: rethink investments

After a careful assessment of the macroeconomic implications of AI, we slightly revise upwards our potential growth for the US to 2.1%. On average, we expect AI to raise US productivity growth further from 1.6% to 1.85% per year over the next 10 years. The benefits should be felt mainly later in the decade as AI adoption rises throughout the service sector. This rise in US productivity may sound small, but the improvement starts from an already high level compared to recent history.

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At the same time, the contribution to potential growth in the US from demographics should slow to only 0.4%, on the back of an ageing population and recent immigration curbs. In the US, we further attribute a negative impact on US potential growth to trade policies and the overall erosion of US institutional credibility, which we estimate at -0.15%. We expect these negative impacts to fade over the course of the decade and possibly be reversed by a future administration. Coupled with an increase in AI adoption, this leads us to expect a steep increase in US potential growth to 2.4% by the end of the decade, averaging 2.1% over the period.

Conversely, our assumption for most European economies remains within the range of 1.0% to 1.5%, while we expect China’s potential growth to slow to 3.5%. This is still above G7 economies, but significantly lower than previous decades.

After the pandemic shock, inflation is back at target

Following the uncertainties of the post-pandemic period, the global inflation picture is clarifying. Evidence suggests that the underlying dynamics are broadly unchanged, despite exceptionally high inflation rates in the 2021-23 period. The drivers of that inflationary spike were temporary – post-pandemic supply chain disruptions, the Russian gas supply shock – and their impacts are now clearly behind us.

We therefore expect inflation trends over the cycle to be once again broadly consistent with central banks’ targets. We think the risks of persistently high inflation are limited, and we do not expect deflationary risks to re-emerge, either. The scars of the Global Financial Crisis led to a protracted deleveraging cycle that saw precautionary savings rise amidst efforts to repair balance sheets, contributing to deflationary concerns. No such conditions apply today. Unlike during the Global Financial Crisis, the crisis response to the pandemic was so extensive that it left private-sector balance sheets healthy and risk appetite robust. 

We think the risks of persistently high inflation are limited

Interest rates pulled higher by wider deficits and investment needs

The final macro variable of critical importance to our framework is the equilibrium rate of interest. This is the interest rate that stabilises the economy at full employment with inflation at target over the long run. This neutral rate plays an important role in determining the path of monetary policy, but its precise level is subject to considerable uncertainty.

Demographic ageing and a shift towards higher inequality in major economies have driven equilibrium interest rates structurally lower in recent decades. Rising life expectancy translates into higher retirement savings. An unequal income distribution also results in higher savings as wealthier people save at higher rates while consuming a smaller share of their income. These factors exert downward pressure on interest rates.

Shifting global investment needs and a changing fiscal picture act in the opposite direction. The need to secure and diversify supply chains, finance the sustainability transition, and increase defence spending in response to geopolitical uncertainty along with higher productivity growth and spending on AI data centres are all pushing investment higher. Coupled with an increased willingness to run a wide budget deficit, particularly in the US, this shift means an increase in government debt, and an associated increase in the interest rate required to absorb it.

Reflecting this changed reality, we have confirmed our revisions of equilibrium interest rate estimates higher, compared with the previous cycle. The exception is China, which we have revised from 3% to 2%. The US continues to lead advanced economies, with the neutral Fed Funds rate at around 3.5%. In other economies, neutral rates are closer to previous cycles given smaller budget deficits and slower increases in debt-to-GDP ratios. We estimate around 1.5% for the euro area, 2.5% for the UK, 0.5% for Switzerland, and 2% for China.

To read our full risk-return assumptions by asset class, download the ‘Rethink Capital Market Assumptions’ publication below.