Long View Q1: Equity and bond risk premia

Return forecasts for the next decade are similar versus the end of 2023, although the return outlook between equities and fixed income has continued to narrow
The flattening of the efficient frontier over the past year reflects an environment of compressed equity premia concurrent with continued repricing higher in real yields as the Fed continues to implement tight monetary policy
The narrowing between equity and bond risk premia reflect sanguine macroeconomic conditions, particularly optimism around the transformative impact of AI and its benefits to corporate profitability. Sustained higher real yields also reflect the resilience of the global economy and the Fed’s hesitance to preemptively pivot back to easy monetary policy.
Bond risk premia do not reflect significant inflation risk premia which have narrowed over the past year. The shrinking of inflation risk premium suggests that nominal treasuries may still possessive strong diversification characteristics versus risk assets.

Summary

In this report, we present the DWS long-term capital market assumptions for major asset classes as of the end of March 2024 while exploring the risks to these forecasts.

The first quarter of 2024 carried over strong price momentum from last year, bolstered by a resilient global economy despite the restrictive monetary backdrop across most major economies. The MSCI ACWI equity index was up 8.1% in Q1, led by continued strong returns from the S&P 500 which returned 10.6%. The Bloomberg Global Aggregate Index was flat in Q1 as US Treasury yields moved modestly higher while corporate and sovereign credit spreads tightened alongside the equity market rally.

The US labor market exhibited continued resilience, posting strong payroll and wage growth in Q1. As a result, US Treasuries sold off, with the 10-year yield moving from 3.88% at the end of last year to 4.02% at the end of March. The move in shorter-term yields was even more pronounced, with markets pricing out the start of Fed interest rate cuts well into the summer months. The 2-year US Treasury yield sold off from 4.25% at the end of December to 4.62% as of the end of March. Looking at the the Fed Funds Futures market, the December contract implied Fed Funds rate moved to 4.69% where the same contract implied a December 2024 average Fed Funds rate of 3.83% as of the end of last year.

Despite being more than two years into this monetary tightening cycle, risk markets have remained resilient both in terms of corporate profitability but also reflecting more expensive valuations and far tighter risk premia, particularly when considering higher base levels in real yields. Across global equity markets, there is increasing bifurcation between technology leaders and more traditional industries, and optimism around the profitability of technology firms continues to put downward pressure on equity risk premia. Conversely, bond risk premia have repriced higher as the Fed has both lifted interest rates and continued with its gradual balance sheet decumulation, with long-term real interest rates now higher than they’ve been in over a decade.

Our 10-year forecasts continue to look increasingly favorable toward fixed-income that reflects higher starting yield levels but bear the risk of owning nominal return assets in a elevated inflation regime. Equities, meanwhile, possess inflationary characteristics that help support nominal return potential but remain challenged by elevated valuations.

Our models now forecast an annual local currency return of 6.1% for the MSCI All Country World Index (“ACWI”) over the next decade, versus 5.9% three months prior as well as an increase for the Global Aggregate Bond Index from 3.2% to 3.5%. At an aggregate level, we estimate the forecasted rate of return on a diversified portfolio at 5.7%**, 0.1% lower from the level at the end of Q2.

^{**DWS Calculations for a strategic asset allocation that targets volatility of 10%}