Large-cap U.S. equities are expected to fall 1.5% on an average annual basis over the next seven years, according to the latest forecast from GMO. Small caps are expected to be up 1.4% over the period while ex-U.S. equities, particularly emerging market equities, look more attractive by comparison.
Fixed income's picture looked less appealing. Real returns on U.S. bonds are expected to be -3.8%, while international bonds could be still lower. Emerging market debt, like its equity counterparts, is expected to return 3% annually.
Researchers attributed their equity forecasts based on relative valuations, noting the large valuation gaps between large-cap equities and their small-cap and emerging peers. The latter groups' already low valuations, or cheapness, has been further magnified by the recent market downturn. Adding to emerging markets' potential is the dollar's relative strength compared to many emerging market currencies.
GMO did not account for alternative allocations that are looked to bridge the gap in returns for institutional investors with return targets needed for liability funding. Historically, U.S. equities grew 6.5% on a long-term inflation-adjusted basis. The average U.S. public plan's long-term return assumption was 7.2% as of Dec. 2019, down from 7.6% in 2014, according to the Public Plans Database.