SUMMARY
Our long-term estimates of equities, fixed income, and other asset class returns play a central role in the long-term investment plans we create for each client. We recently updated these key figures.
Determining a suitable mix of asset classes to hold for the long term – aka strategic asset allocation – is one of the most important jobs we face as investors.
To make this key decision, we need to have a view about how different asset classes might do over the coming years.
Valuations impact future returns
At Citi Wealth, we use current valuations to help forecast future asset class returns.
In our analysis, we have found that cheaper valuations have tended to be followed by higher returns.
And more expensive valuations have tended to give way to lower returns.
Figure 1. Lower valuations have seen higher subsequent returns in US equities
Source: Bloomberg, Citi Global Wealth as of 14 Apr 2024. The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or P/E 10 ratio, is a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher-than-average CAPE values implying lower than average long-term annual average returns. It is not intended as an indicator of impending market crashes, although high CAPE values have been associated with such events. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
The forecasts of future asset class returns that we rely on are called “strategic return estimates” or SREs. Strategic return estimates are based on indices. They are Citi Global Wealth’s forecast of returns for specific asset classes over a 10-year time horizon.
These forecasts represent potential annualized returns over a ten-year period. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events.
All else equal, our methodology allocates more to asset classes with higher return estimates and less to those with lower expected returns.
Our return outlook has changed
Normally, we update our SREs toward the end of each year.
In 2024, though, we have decided also to refresh them for the half-year stage, as we recently wrote in Wealth Outlook 2024: Mid-Year edition.
Figure 2 shows our latest SREs and the figures from the two previous full years.
So, how to interpret these?
Clearly, SREs are lower than they were at the start of the year. Nonetheless, they still point to decent returns in many cases.
Our SRE for Global Equities is a 6.4% over a decade, Global Fixed Income 5.3%, and Cash 3.2%, for example.
And Emerging Market Equities, Private Equity, and Real Estate strategic return estimates suggest potential double-digit returns between now and 2034. These estimates may not be achieved due to market and changing global economic conditions.
Likewise, the Fixed Income sub-asset classes’ SRE implies attractive potential, at least compared to the era around 2020 when ultra-low and even negative bond yields prevailed.
|
Mid-2024 Year SRE |
2024 SRE |
2023 SRE |
Global Equities |
6.4% |
8.7% |
7.6% |
Developed Market Equities |
6.0% |
8.2% |
7.0% |
Emerging Market Equities |
10.4% |
12.8% |
12.9% |
Global Fixed Income |
5.3% |
5.8% |
5.1% |
Investment Grade Fixed Income |
5.1% |
5.4% |
4.6% |
High Yield Fixed Income |
6.3% |
7.9% |
7.4% |
Emerging Market Fixed Income |
7.1% |
8.1% |
7.8% |
Cash |
3.2% |
4.3% |
3.4% |
Hedge Funds |
8.5% |
11.5% |
9.1% |
Private Equity |
14.6% |
19.5% |
17.6% |
Real Estate |
10.8% |
10.9% |
10.6% |
Commodities |
2.6% |
2.7% |
2.4% |
Source: CGW Strategic Asset Allocation and Quantitative Research Team. Strategic Return Estimates (SREs) for Mid-Year 2024 (based on data as of April 2024), prior Strategic Return Estimates for 2024 (based on data as of October 2023) and 2023 SREs (based on data as of October 2022). The Strategic Return Estimates are calculated annually and can be reassessed periodically.*
Rising valuations, falling SREs
Financial markets have got off to a lively start in 2024.
The US equity market – which makes up most of developed market stocks globally – has risen over 20%. Other developed markets are also up almost 20% in aggregate, and emerging markets are some 16% higher since the beginning of the year.
These gains have pushed their valuations up somewhat, which in turn lowers our SREs.
Some public equity valuations are also inputs to our calculations for Private Equity and Hedge Funds, so SREs have moved lower here too.
Likewise, strong performance by High Yield and Emerging Fixed Income have seen yields and hence SREs fall.
How we’ve changed our calculations
Market moves are only part of the story, however. We have also adjusted how we calculate our SREs.
In equities, we found that some loss-making companies had historically distorted small-cap equity valuations.
When estimating returns, our methodology compares current valuations to their long-term average.
A valuation below its long-term average has often given way to positive returns as the valuation reverts toward that average over time.
However, past losses in US small caps meant the long-term average was too high, in our view.
This made today’s valuations look cheaper than they really were compared to their history.
As a result, this raised the return estimate for US small-cap equities, private equity and hedge funds.
To be more conservative, we therefore decided to change the index that we use to represent small-cap equities.
Rather than the MSCI US Small Cap Index, we now use the S&P 400 Index, which contains higher quality companies less likely to be loss-making.
As we’ve seen, this led to lower – but in our view, still attractive – SREs in Developed Equities, Private Equity, and Hedge Funds.
We’ve also tweaked how we forecast returns for Cash.
Previously, we used the most recent yield on Treasury bills. However, this led to a more volatile SRE.
We have therefore shifted to a calculation that incorporates smoothed rates from prior periods.
Again, we feel this to be more conservative as reflected in the lower SRE for Cash.
The bottom line
Our approach to strategic asset allocation is dynamic: as the outlook for risk and returns shifts, so do our forecasts.
We have also reviewed our allocations and there is no meaningful change in them warranting any updates as of mid-year 2024.
While the principles that guide our approach to asset allocation are steadfast, we are open to improving the inputs, as these latest changes show.
However, the conclusions we draw from them still stand: We continue to believe that globally diversified allocations may see attractive annualized returns over the coming decade.
