2018 represents something of a watershed moment for our long-term economic outlook. Over the past decade, worsening demographic trends, such as sluggish population growth coupled with a large wave of retirees, drove successive downgrades to our estimates of trend growth, but it appears this sequence of downgrades might be nearing an end. For the first time, we can see upside risks to our baseline long-term trend growth expectations starting to emerge.
It's late in the economic cycle, after eight years of growth in the U.S. Stocks are a little pricey, bond yields are relatively low and expected capital market returns are weak, presenting a challenge for investors. But other things being equal, a stabilization of longer-term growth could mean better returns in both stocks and bonds. True, they are down from where they were 25 years ago, but the gap between investor goals and what seems achievable is no longer widening.
Given this view, there are two things that investors need to do:
1. Manage the cycle challenge over the next few years. While we believe the economic outlook over the next 12 to 18 months looks positive, at some stage during our 10- to 15-year long-term horizon there will inevitably be a period of slower growth and contraction, and that's going to be a challenge. But with appropriate use of diversification, a reasonable degree of active management and efforts to build robust portfolios, there are plenty of tools available today that can help weather the storm when it eventually comes.
2. In capturing those stabilizing long-term returns, look to access a broad base of asset classes. If you look at the stock/bond frontier, there are a lot of assets that cluster quite close to it. That tells us that if we build portfolios using a deep and thoughtful opportunity set then we will have a lot of opportunity to seek sources of alpha and deliver better investment outcomes. It's a world where we can expect slower growth and lower returns, but it's not an insuperable challenge.
Since the financial crisis, 60/40 portfolio returns have earned about 11% annualized, which is one of the more impressive return periods in living history. In short, it has been a good time to be in the market: coming out of the financial crisis, most assets were cheap. But if we do nothing different, given today's higher valuations, returns over the next 10 years will be just half that. This year, our expected return for a U.S. dollar-based 60/40 portfolio is slightly lower at 5.25%, vs. 5.5% last year. We need to come off autopilot and grasp the opportunities of a stabilizing growth outlook over the intermediate term.
One place to look is emerging markets, which are growing at a higher pace than the developed world.
Yes, demographics there are moderately better, but the real separating factor is convergence to the technological frontier: taking developed market technology and business best practices and applying them to emerging markets. This amounts to more skilled workers and more capital, both of which are components of productivity. That's the real differentiator. Productivity catch-up means faster economic growth.
We see a 3% growth wedge between emerging and developed markets, which has a couple of effects. First, it gives us a bit more confidence that over the longer term we will see aggregate global growth levels plateau and then begin to pick up, simply because the growth mix will over time contain more of this higher component coming from emerging markets. Secondly, it means that if investors are looking for growth, they will probably skew their portfolios more toward emerging markets than developed markets, relative to current benchmark weights.
Within developed markets, of course, you still get capital gains coming through the equity markets, but that accounts for about a third of our return expectations within the major developed markets while two-thirds comes from income. In the emerging markets, it is the other way round, with two-thirds of the expected return coming from capital growth and a third from income. So, capital growth-seeking investors are likely to find themselves attracted toward higher growth regions in emerging markets. In addition, the structural concerns we have had about emerging markets are beginning to dissipate. Of course these are still higher-risk investments and that is reflected if you look at their risk-adjusted returns. But the reality is that things such as concern about the debt load of many emerging market countries have eased meaningfully, current account balances are improving, and structural and institutional strength is gradually getting better. As a result, emerging markets now look like an interesting place to boost long-term returns within a balanced portfolio of assets.
China is particularly worth notice. It represents 15% of the world economy and yet only 2% of the $10.8 trillion bond market is owned by foreigners. By comparison, about 45% of the U.S. Treasury market is held by non-U.S. investors. What's been seen over the past couple of years is that the People's Bank of China and the other authorities in China are making steps toward gradually liberalizing access to their markets. We believe that attracting overseas investors into Chinese assets and providing stable market conditions are important goals for Chinese policymakers, which probably means a very gradual transition to market-set interest rates. Chinese interest rates likely will eventually need to be higher than they are under the current structure, but that's something that has to happen relatively slowly. It will be an evolution, not a revolution. Nevertheless, we believe that Chinese markets will, over the next 10 to 15 years, become a much larger component of the investible asset universe around the globe.
In our framework for assessing long-term capital market return expectations, we assume that what you get out of markets relates closely to what you get out of economies. While our overall growth expectations — and by extension our return projections — remain low by historical standards, they do at least seem to be stabilizing. And in looking to emerging market economies, we think that faster growth there will over time translate into highly useful excess returns to bolster balanced portfolios.