05/05/2021 | News release | Distributed by Public on 05/05/2021 04:47

Testing the Limits of Reflation

By HENRY H. MCVEY May 05, 2021

Testing the Limits of Reflation

If ever there were a time to champion the mantras of our founders George R. Roberts and Henry R. Kravis to build like and trust, act with integrity, and lead by example, we believe that now is that time. The re-opening we are envisioning will not be a straight line, and the pandemic has laid bare multiple inefficiencies - and more importantly, inequalities - that need immediate fixing, particularly in developing countries. However, there are also reasons to be optimistic. Vaccine roll-outs are accelerating, and economic growth is poised to surge, which should boost both employment trends and income levels. Consistent with this view, we are upgrading our earnings forecast and year-end target for the S&P 500 and boosting our 10-year interest rate forecast for the next few years to reflect stronger growth in nominal GDP. At the same time, we also have completed a refresh of our long-term expected returns, an important exercise that leads us to believe we have entered a new, more complicated era for global asset allocation. Against this backdrop, we continue to rely heavily on our Another Voice framework, which continues to suggest sizeable positions in Public Equities, Collateral-Based Cash Flows, and Private Investments.

One belongs to New York instantly, one belongs to it as much in five minutes as in five years.

Tom Wolfe American author and journalist

While author Tom Wolfe's famous quote about how easily New York City can cast its spell on those who visit might seem somewhat outdated amidst the COVID-19 pandemic, we are increasingly confident that 'Gotham' - and many other global urban centers across Asia, Europe, and Latin America - are poised to begin to once again assert themselves as important hubs of interconnectivity and economic output. Modernization, industrialization, collaboration, and the arts and culture are still valid concepts of human society that - even in a post pandemic world - will again lure individuals back to large cities, we believe.

However, the re-opening we are envisioning will not be a straight line, and the pandemic has laid bare multiple inefficiencies - and, more importantly, inequalities - that need immediate fixing. Just consider that today nearly 44% of those unemployed in the United States have been so for 27 or more weeks. Statistically speaking, this sub-segment of the U.S. population typically has only a one in five chance of successfully securing a permanent position. Unfortunately, such socioeconomic inequalities are not restricted to just the United States. In Europe, for example, my colleague Aidan Corcoran's estimates suggest that the COVID shock may have undone fully five years of progress on income inequality. Outside the developed economies, our concerns about human safety and well-being in several countries like India, Brazil, and Turkey are now even more pronounced.

Yet, there are also reasons to be optimistic. Authorities in most major economic regions are pushing hard on the fiscal impulse designed to ameliorate these inequalities as well as spur growth at a time when financial conditions are quite accommodative. Moreover, vaccinations are ramping upwards in many places, and global savings are now high enough to encourage a sustained increase in spending across both small towns and big cities, we believe. In fact, our work shows that the recovery is likely to be much more front-end loaded than what we saw after the Global Financial Crisis (GFC).

So, while the human element remains raw and there are many lessons to be learned, we must also look ahead, particularly those of us who are charged with managing retirement money on behalf of pensioners, first responders, teachers, and non-profits. Indeed, if there was ever a time to champion the mantras of our founders George R. Roberts and Henry R. Kravis to build like and trust, act with integrity, and lead by example, now is that time.

Consistent with this approach, we have updated our macro frameworks to share, discuss, and debate with our fellow workers, our existing limited partners, and our prospective clients. The good news for those with whom we interact on the macro front is that we now have even more confidence in our Another Voice thesis for 2021, as our top-down framework argues for a more reflationary tilt on the portfolio construction front.

In terms of what is new in this latest piece, we drill down on four key areas of macro focus that we think warrant investor attention, as fiscal and monetary policies test the limits of reflation. They are as follows:

1. We are upgrading both our earnings forecast and our year-end target for the S&P 500. Specifically, we are lifting our 2021 fair value forecast to 4,320 from 4,050, based on S&P 500 earnings per share of $185, compared to $174 previously and a current consensus of $181. We also introduce a 2022 forecast of 4,620, along with $207 in earnings next year versus a consensus forecast of $205. Our new price target assumes a forward P/E of 20.9x (approximately 1.8x below current level). As we detail below, the composition of earnings is shifting heavily towards more cyclical parts of the economy, we believe. Importantly, though, while we are boosting our target for 2021 and 2022, we would not be surprised to see some consolidation after such a strong first four months of the year.
2. We are also increasing our U.S. 10-year interest rate forecast for 2021 to 1.75% from 1.50%. Our 2022 forecast goes to 2.25% from 2.00%. We model rates, GDP, and inflation out to 2025 to better understand the path of interest rates. We still do not see rates getting unglued at the long-end of the curve, but we do expect that faster growth, more government spending, and complications linked to supply chain disruptions (think the Suez Canal) all combine to make us want to take a slightly more conservative approach to rates. That said, we are not changing our long-held framework that predicts some ongoing consistency in the relationship between nominal GDP and nominal interest rates. Also, there are some important technical offsets we have found that may limit the upward pressure we are forecasting for rates. Details below.
3. While nominal rates are increasing, real rates - which we believe are key to financial conditions - will remain at attractive levels for the foreseeable future. As part of our deep dive on real rates, we compare to past periods to see what it means for asset class returns. See below for details, but our punch line is that we are still in an extremely accommodative backdrop for financial assets, Equities, Real Estate, and Infrastructure in particular. To be sure, our sentiment indicators are signaling an increased risk of a near-term correction after such a strong start to the year (Exhibit 13), but our work gives us additional confidence that now is the time in the cycle to maintain overweight positions in collateral-based cash flows (e.g., Infrastructure and Real Estate) and Equities (Exhibit 51).
4. Given the changes we have made to our equity and interest rate forecasts, we have refreshed our expected return forecast for the next five year period; not surprisingly, sporty margins, high multiples, and low interest rates still all suggest lower returns ahead. That said, we still see opportunity in many portions of the market. In particular, as part of our shift towards including more Real Assets in portfolios via our focus on collateral-based cash flows, we think that the case for Infrastructure and Real Estate have strengthened materially. We also see significant differentiation in the Public Equity markets, as we expect Small Cap and Emerging Markets to finally best the S&P 500. See below for details.

In terms of the key macro themes embedded in our Another Voice framework, we continue to focus on the Big Six mega themes we originally laid out in January. They are as follows:

• We are bullish on collateral-based cash flows. Asset-Based Finance, Infrastructure, and many parts of Real Estate should perform well in the faster nominal GDP environment we are envisioning. The value of the sound collateral that backs the cash flows can further enhance performance, particularly if investments have strong pricing power characteristics and are linked to some of our key themes (e.g., nesting, growth in data, resiliency). This remains a table pounder for us, especially given the unusual backdrop of rising cyclical inflation, more stimulus, and higher commodity prices.
• Given record low rates and the campaign against austerity, investors should back fiscal beneficiaries, particularly as it relates to ESG. Climate change and the transition to cleaner energy, which we think could be a three trillion dollars per year global investment, are clear areas of focus for many investors. This transition will implicate multiple industries as companies and consumers embrace more sustainable products, more energy efficient real estate, and more innovative transportation. We also continue to prioritize opportunities that benefit from COVID-related structural tailwinds across areas like education/work-force development, waste management, public and private health, and industrial technology. Finally, given rising geopolitical tensions as well as the more frequent weather-related events such as occurred in Texas in February 2021, we see infrastructure 'resiliency' as an influential investment theme, particularly as it relates to supply chains and power distribution.
• The rise of the global millennial is upon us. In the United States, the 68 million millennials are now at an age where they are buying houses, spending on their families, and shifting their consumer preferences. Moreover, in Asia there are now more than 800 million millennials; their changing behavior at a time of huge technological transformation will have significant implications for all aspects of the global economy. If we are right, then our nesting theme has more room to run. The millennial consumer will also reinforce the ESG and sustainability trends mentioned earlier.
• Though COVID-19 is only accelerating this trend, local bias preferences by both governments and corporations are leading to major shifts in the global supply chain, including an intensifying focus on resiliency. Our strong belief remains to invest behind this transformation. Reshoring of property, plant, supply chains, and equipment will be an attractive investment area; already, we note that announcements linked to supply chain expansion in the U.S. are up a sizeable 176% year-over-year in 2021, based on research from the investment bank UBS.
• We think that more volatility and more dispersion lie ahead. Not surprisingly, we favor flexible mandates such as Opportunistic Liquid Credit, particularly managers who can toggle between High Yield, Loans and Structured Credit, as well as Real Estate Credit funds, including those that can move up and down the capital structure. Funds that also benefit from market dislocations and can deliver capital solutions should do well in the environment that we envision.
• Despite our desire to ride the cyclical wave in the economic growth we are forecasting, we do not believe that Growth investing behind secular winners should abate. Our distinct preference is less for Venture Capital and more towards Growth ideas in sectors such as Healthcare, Technology, and Consumer. The reality is that Technology is no longer a distinct sector; rather, it is now woven through every industry in which we invest, a backdrop that creates an attractive environment to back long-term champions of innovation. However, unlike the last 2009-2019 economic cycle, valuation will now matter more on a go-forward basis.

Looking at the bigger picture, we think that we are entering a period of higher short-term inflation (Exhibit 3). Not surprisingly, in the near-term this view is likely to put upward pressure on interest rates. That outcome, as we show in Exhibit 5, is actually wholly consistent with most prior cycles. It is also worth noting that the Treasury markets historically have overestimated the persistence of early-cycle inflation, as 10-year yields and break-even inflation actually surged the most in the early parts of the last two recoveries. Moreover, as we show in Exhibit 4, the money multiplier - which we view as a key ingredient to inflation - has yet to accelerate.

To be sure, we will be watching interest rates closely and there is a risk that Treasury supply overwhelms demand (Exhibit 23), but we do not see rising interest rates as the Achilles heel that derails the current recovery. As we detail later, rising rates - when accompanied with strong growth - are not to be feared, particularly if financial conditions remain accommodative. Moreover, the dollar remains well bid, which is important for maintaining grounded inflation expectations at the long-end of the curve. Importantly, foreign buyers, including China, have started to buy U.S. Treasuries again (Exhibit 29), which should help to dampen some of the glut of supply we are forecasting (Exhibit 23). So, ultimately, we see rates increasing and we definitely expect more volatility along the way. However, the outlook for 2021 and beyond for those who embrace our Another Voice thesis is still quite compelling, we believe, particularly for those individuals and institutions that have the flexibility to harness both the illiquidity premium in the private markets and lean into dislocation in the public markets.

The other key variable on which we all need to focus is pricing power. We have now entered a period where input costs are increasing faster than consumer prices. One can see this in Exhibit 7. This type of environment, which is really quite different from the 2009 recovery (when input costs were slow to increase), heavily favors companies with pricing power. Indeed, we think we have entered a world where companies with pricing power, or what we term price makers, will be re-rated upward at the same time that price takers will be de-rated. This bifurcation is not to be underestimated, as the consensus now suggests that almost all the companies in the S&P 500 will deliver improving margins (Exhibit 6). In our humble opinion, these forecasts will prove way too optimistic, leading to heightened volatility during the summer months, as margin estimates are ratcheted down.

Section I

We Are Upgrading Our EPS and S&P 500 Target to Reflect Stronger Growth

If there has been a 'north star' that we have followed since starting in macro at Morgan Stanley in early 2004, it has been our Earnings Growth Lead Indicator or EGLI. It has consistently helped to capture major turning points in growth cycles and importantly, when we look at it today, is pointing up and to the right. One can see this in Exhibit 8. Key inputs such as housing, financial conditions (i.e., credit spreads), and consumer confidence all suggest more and faster growth ahead.

We also want to flag that our model does not directly capture the additional pandemic-related stimulus that has been layered into the U.S. economy. All told, my colleague Dave McNellis estimates consumers will have banked about $2.5 trillion in extra savings by year end, equivalent to 17% of pre-pandemic annual consumption spending. Not all of those dollars will get spent at once; rather we think that they will support a multi-year expansion. Importantly, much of the extra savings have built up at the high end, as lockdowns have curtailed upper-income spending on travel and leisure. Excess savings therefore should help catalyze big-ticket discretionary spending amid re-opening.

Also, there is the potential for more spending. Indeed, after passage of a $1.9 trillion COVID relief package in March, all eyes in Washington, DC are now turned towards at least an approximate four trillion infrastructure package. While President Biden has set the debate in motion, Democrats in Congress must now do the difficult work of crafting a package that can pass both the House and Senate with their razor thin majorities. For the moment, they are pursuing a dual-track approach, each of which aligns expenditure components with proposed offsets from tax increases. The first track, which contains approximately $2.4 trillion in outlays, bundles conventional, physical infrastructure - roads, bridges, water projects, etc. - with increases to corporate tax rates. The second tranche of about $1.8 trillion in outlays, or the 'human' infrastructure component, focuses on a broad assemblage of social programs and spending - including child and health care - and is bundled with increases in personal tax rates, particularly for upper income earners. The potential political and policy permutations of a deal are innumerable at this stage and will likely come in lower than the initial projections. However, the key fact on which to focus is that the Democrats - to the extent that they can stick together - intend to 'go big' (i.e., expect more spending, sooner), having learned a hard lesson during the Global Financial Crisis when policy makers did not go nearly 'big' enough. Democrats also appear to have learned from climate action's failure in 2009 when some Democratic legislators from industrial regions came to view cap and trade as a threat to their jobs. This time, by comparison, President Biden's climate proposal emphasizes green infrastructure, including for the electric vehicle, which will create U.S. industrial jobs.

So what do all these monetary and fiscal tailwinds mean for the S&P 500? Despite growing concerns about a potential near-term correction (Exhibit 13), we are raising our S&P 500 2021 fair value estimate to 4,320 (up from 4,050 previously), on the back of higher 2021 EPS of $185 versus $174 previously and a current consensus of $181. The approximately $11 upgrade reflects greater fiscal stimulus (Biden has exceeded expectations by a wide margin), acceleration in consumer spending, and stronger-than-expected 4Q20 earnings (15% above consensus expectations). Rising rates and steeper yield curves accrue to the benefit of Financials, while bull markets in copper and oil are a boon to Industrials, Energy and Materials. All told, these four cyclical sectors plus consumer discretionary are expected to drive over two-thirds of the EPS growth this year and close to 60% in 2022e (Exhibit 11). This is a marked departure from the 2012-19 period when the three 'secular growth' sectors - Technology, Communications and Healthcare - accounted for 64% of the earnings growth.

We are also introducing our 2022 EPS estimate of $207. Our EGLI actually suggests growth of 15%, but we have moderated our official outlook to 11.5%, or $207 per share, to account for the combined impact from higher taxes, rising input costs, and higher wages (our channel checks suggest this issue will be a major one through at least September 30th). The consensus for 2022 is $205, but we do not think it is fully tax-rate adjusted. We are also establishing a 2022 forecast for the S&P 500 of 4,620. Our new price target assumes a forward P/E of 20.9x (approximately 1.8x below current levels), as we expect strong earnings growth, rather than multiple expansion, to drive the next leg of the equity rally (Exhibit 10).

While price-to-earnings multiples appear high in absolute terms, our valuation models suggest that the equity risk premium (ERP) is not yet out of whack. In fact, while today's implied equity risk premium is low relative to the post-GFC period, it is still quite elevated versus its longer history. Strong housing, pent-up demand, historically high savings, and a Fed that is committed to overshooting its two percent inflation target should support a higher risk appetite. As such, we are lowering our ERP estimate to 4.70% from five percent previously. Importantly, risk appetite is nowhere near the exuberant levels (two to three percent) leading up to the tech bubble burst in 2000 (Exhibit 12).

We also want to underscore that the impact of higher rates does not derail our thesis. In terms of specifics, we are embedding a higher 10-year U.S. Treasury yield of 1.75% in 2021 and 2.25% in 2022. While the impact of higher rates can sometimes be a headwind to valuations, interest rates are going up for the right reasons (i.e., higher growth expectations and pricing power). Similar to past cycles, better growth increases cash flow and pushes credit spreads lower, which should more than offset the adverse impact from a higher risk-free rate, we believe.

Section II

We Are Also Lifting Our Interest Rate Forecast, but We Now Have More Conviction That Rates Are Not Going to Get Unglued At the Long-End

As we indicated earlier, we are boosting our interest rate forecast to 1.75% this year from 1.50% and our forecast for next year goes to 2.25% from 2.00%. By 2025, we see yields at 2.50%, or maybe a little higher. In updating our forecasts, we spent a considerable amount of time pressure testing our traditional interest rate framework, which we describe below in some detail. We also researched a few other strategies to forecast rates, given the complexity of the current macroeconomic environment. In addition, we looked at some technical factors, including supply and demand, which support our view that U.S. 10-yields are not on the verge of unraveling. Importantly, all our models suggest higher rates, but they do not suggest a surge in either near-term or long-term rates the way some bond bears are now growling.

Our Traditional Framework As one might expect, we think getting interest rates right is one of the most important drivers of outperformance in the macro and asset allocation arena. Key to our thinking is that government bond yields form the base for price discovery in almost all other fixed income asset classes, and as such, they shape how and where investors allocate capital across the global fixed income universe, in both liquid and illiquid markets. Interest rates also impact cap rates and drive equity multiples. So, if there is one question investors need to get right in today's environment of unprecedented monetary and fiscal stimulus, then we think it is linked to the direction of U.S. interest rates. At its core, we view interest rate policy as being inherently linked to nominal GDP growth. Importantly, though, while U.S. interest rates and U.S. nominal GDP growth are highly correlated, the relationship is not static over time. To this end, Exhibit 17 illustrates the different regimes of yields relative to nominal GDP that have existed since the 1950s. While regimes have varied, what we think stands out is that in the U.S., interest rates have tended to run moderately below the level of nominal GDP growth as long as the Fed was not actively trying to suppress run-away inflation. It was only during the Chairman Paul Volcker Fed era of the 1980s that rates ran notably above nominal GDP for a sustained period. Put more simply, we view Fed policy and corresponding interest rates as a function of nominal GDP growth. When growth is too weak, then interest rates are held below nominal GDP to accelerate growth. When growth and inflation are strong, interest rates are often held above nominal GDP growth.

So, where do we see interest rates going? In our Base Case, we envision a continued robust economic recovery underpinned by fiscal stimulus, excess savings, housing, and a heated inventory cycle. Inflation runs above two percent in 2021-22 before slowing back towards the Fed's two percent target. Longer-term inflation remains well-controlled. Our High Case envisions a fiscally-driven overheating as stimulus and excess savings are drawn down faster than expected, which resets inflation expectations higher on a structural basis. Finally, our Downside Case envisions that the recovery disappoints, as COVID variants keep case counts elevated, and trade tensions dent global growth. Longer-term disruptions result in economic scarring. As 'secular stagnation' concerns reassert themselves, inflation remains stuck below two percent and Fed Funds pinned at the zero bound.

Fed Funds/Yield Curve Framework We also tried other approaches to assess where longer-term rates might be headed. To this end, we looked at ten previous Fed hiking cycles to better understand how much Fed Funds typically increase and the resulting impact on the long end. One can see this in Exhibit 20, which shows that rate cycles have historically taken the short rates up by an average of 387 basis points. Interestingly, long rates typically go up 'only' by about 30-40% relative to what the short end does. Our work suggests that, were this relationship to hold this cycle, long-rates would go up by 70-100 basis points (depending on whether you look at the average or median) to around three percent or so, which is above both what we and the forward curve are forecasting. We can take some comfort that three percent is not that far above our base case analysis, but we certainly will be watching this relationship more closely in the future to make sure that we are not being too optimistic with the traditional model we described earlier.

As we have heard described by some investors, the bear case on interest rates centers around the risk that supply could overwhelm demand amidst heavy deficits. All told, as Exhibit 23 shows, there is $1.7 trillion of supply coming to market just this year on a net basis (i.e., after buybacks). No doubt, this risk is real, and it is one on which we will be laser focused as a macro team.

However, there are some important offsets to the supply-driven bear case that rates spiral out of control, or frankly, even the more modest upward pressure we are forecasting in our base case. We note the following points for investors to consider:

Point #1: U.S. Rates Look Attractive Relative to Their Global Peers: On the technical side, we see the incredibly low global rates environment as a further constraint on U.S. rates. Consider for example that if today's U.S. 10-year yield feels low on an absolute basis at 1.7%, it actually offers a lot of relative value for a German investor, as an example, whose local market bonds yield negative -0.3%. The spread between U.S. and German rates is at 167 basis points and although the spread may further widen this year, we don't see it approaching the rarely reached 250 basis points threshold (Exhibit 25).

Point #2: The U.S. Dollar Is Not Collapsing, Which Keeps Inflation at Bay: According to our models, the U.S. dollar is currently only about three percent overvalued, after falling from its approximate 10% peak in mid-2020. We think that this is important for maintaining grounded inflation expectations at the long-end of the curve and believe that it suggests that the USD will not collapse the way it did during some prior inflationary cycles. The reality is that U.S. growth is stronger than that in many other parts of the world, and the nominal yields on U.S. Treasuries are becoming competitive again.

Point #3: Average Inflation Targeting (AIT) Means the Short End of the Curve Will Not Be as Reactionary to Growth as In the Past: Recall that the Fed changed its policy last fall and now has a higher bar for raising short rates. Specifically, it has incorporated maximum unemployment, which is now viewed as a 'broad and expansive' goal, along with inflation above two percent (and the potential it stays there for some time) as part of its mandate. To that end, the Fed wants not only to drive unemployment back down to 3.5%, but also to do so in a way that is inclusive by race, gender, and income. This approach gives them a lot of wiggle room to be able to tell the markets that 'we are not there yet' in terms of tightening financial conditions. So, our bottom line is that, while the yield curve can steepen, the chance of the Fed abruptly hiking the short end (as it did in 1994) is extremely remote only a year into its new strategy.

Point #4: China Is Beginning to Buy Treasuries Again, and the Fed May Be Doing More Than Some Folks Think: Foreign buyers, including China, have started to buy U.S. Treasuries again, which should help to dampen some of the supply glut we are forecasting. As one can see in Exhibit 29, the start of Chinese buying coincided with the election of President Biden. We do not view this as only a response to the U.S. election, but also China taking action to build foreign exchange reserves and slow appreciation of its currency. Meanwhile, the Fed recently has been 'overshooting' its $40 billion per month objective, although we acknowledge much of the increase was linked to the increase in rates.

Point #5: Most Everyone Is Already Bearish On Rates: Fully 90% of investors in a recent Evercore/ISI survey said that U.S. 10-year yields were headed higher, and attribute the move in yields to data and headline risks as well as the volume of investors short the 10-year. If investing is about mean reversion, then clearly this percentage should be lower than 90%.

Our bottom line: We think that rates have bottomed, but we do not see the rate market suffering a 1994-type unwind. For starters, the sizeable spike in inflation that we are seeing is likely to prove transitory. Also, the Fed's new Average Inflation Targeting regime should keep the short end of the curve lower for longer. Implicit in our forecast and the Fed's forecast is that the participation rate will start to increase again in 2022, as unemployment benefits start to wane. Moreover, we note that the Treasury markets historically have overestimated the persistence of early-cycle inflation, as 10-year yields and break-even inflation actually peaked in the early years of the last two recoveries. We also see technological change as inflation dampening at the same time that the money multiplier remains stagnant. Besides downward pressure on inflation from technological change, we do not see the money multiplier accelerating the way some have feared.

Section III

We See Overall Lower Expected Returns, but We Do See Significant Opportunity, Including the Potential to Own More Collateral-Based Cash Flows

As one might expect in today's highly fluid macroeconomic environment, we have been spending an increasing amount of time with our clients discussing future expected returns. Interest in this topic makes a lot of sense to us, given that margins and multiples are high and interest rates low. Despite a tougher starting point, the good news is that, as we describe in more detail below, there is still significant opportunity to generate returns above most hurdle rates if one is willing to adopt our Another Voice framework, a tool kit that relies much more heavily on embracing dislocation and collateral-based cash flows. We also think the impact of the illiquidity premium to overall returns in today's generally low rate environment has likely increased in value - even with rates moving up off record lows in recent months. Finally, given the recent rip upward in liquid markets after the pandemic-induced liquidity surge, we have also spent some extra time analyzing whether now is a good time or bad time to allocate more towards Private Markets. Looking at past performance as a guide, we believe there are quite compelling arguments to be made as to why we expect Private Equity to outperform Public Markets in the coming years. However, Private Equity is not alone, as we see significant opportunity across many alternative asset classes, particularly for capable managers, to meaningfully outperform liquid indexes.

So how did we go about this exercise? Using our rate change in Section II as a catalyst, we asked Frances Lim, who has been forecasting expected returns since the Barton Biggs/Byron Wien era at Morgan Stanley, to update her longer-term forecasting models. What follows is a discussion by asset class of the direction of expected returns over the next five years. The totality of this work is shown in Exhibit 33, which illustrates that future returns will be quite different than past returns.

U.S. Large Cap Equities: Return to Normalcy, Which Likely Means Lower Returns While we expect strong S&P 500 returns over the next 12 months, the longer term outlook is less certain as valuations are high and as interest rates rise, earnings multiples will shrink. At 26.8x trailing earnings, the S&P 500 is 70% above its historic average of 15.8x. Given our out-year forecast for interest rates, we think the trailing P/E could de-rate by about 29% to 19.0x in 2025e. This decline is driven by our expectations for higher interest rates, a lower dividend payout ratio that normalizes back to pre-pandemic levels, and lower EPS growth back to post-GFC levels, with slight offsets from higher nominal GDP growth and a lower equity risk premium. All told, our net adjustment represents an annualized hit of seven percent just from multiple compression. The good news is that we expect a robust profit recovery from current levels of an annualized 9.1% which results in a five year expected return of 3.5% including dividends.

In terms of important details at the asset class level to consider, we note the following:

Russell 2000: Improving Outlook While a handful of equities (i.e., FAAMG) outperformed almost all indices last year, the Russell 2000 actually outperformed the S&P 500 in aggregate in 2020 (20.0% vs. 18.4%). Looking ahead, we think that small caps as measured by the Russell 2000 will retain their leadership position. In fact, we see annualized book value growth of 6.9%, and a yearly cash yield of 1.5%, partially offset by -2.5% price-to-book multiple compression per year. These inputs result in an annualized total return of 5.9% over the next five years (well above our S&P 500 return during the same period).

Emerging Market Equities: Looking Attractive from a Strategic Perspective There are several positive macro factors to consider. First, the composition of the EM index is different today than in the past, which should help to boost returns, we believe. Just consider that in 2010, the index was 29% Energy and Materials versus just 13% Technology. Today, by comparison, the index is only 13% Energy and Materials versus 20% Technology. Second, current valuations are about 20% lower than the S&P 500, even though Technology should receive a higher multiple than cyclical commodity related sectors. Third, the emerging markets of today are much better at managing inflation, with much less volatility than the past, so the risk premium should likely be lower. Finally, pre-pandemic, emerging markets return on equity was structurally bottoming. So, for EM, we have a strong expected earnings trajectory of an annualized 9.2%, 2.5% income return and 0.5% annual currency appreciation versus the U.S. dollar leading to an annualized expected five year return of 6.7%. However, we are watching closely the current COVID wave impacting Asia, Latin America, Africa and the Middle East, and as one might expect, the disease could impact the pace of recovery.

Private Equity: There Is Still Value in the Illiquidity Premium With robust Public Equity valuations, the Private Equity illiquidity premium could be even more attractive, as we head into a lower return world, we believe. Indeed, as we outlined in our 2018 Insights note Rethinking Asset Allocation, the illiquidity premium is negatively correlated with the performance of the listed market. In other words and as we discuss in greater detail below, Private Equity underperforms when the market is on a tear, such as during 2003 and 2009, and more recently in 2017 and 2019. However, during periods of Listed Equities underperformance, the average return for Private Equity is about 16%. The only exceptions to this strong double digit outperformance were the tech bubble collapse and 9/11 in 2001, and the Global Financial Crisis of 2009. The key reason for the outperformance is the focus on value creation through operational improvement as opposed to depending on multiple expansion.

Private Credit: We Continue to See Opportunities Given the low level of rates and the ongoing disintermediation of the traditional banking system, we continue to view Private Credit as an attractive asset class. Within the Private Credit arena, we prefer moving up in size and maintaining a diverse portfolio. In terms of returns, we now look for 5.3% annualized returns, down from 6.9% previously. The catalyst for this change is driven largely by our High Yield forecasts, as Private Credit returns are often closely linked to High Yield returns - albeit with an added illiquidity premium. So, driving the more subdued forecasts are the reality that spreads in High Yield have tightened sharply of late on the tailwinds of both outsized monetary and fiscal support.

Real Estate: Stay the Course In Real Estate, we anticipate an unlevered expected return in private Real Estate of 6.5%, which makes it amongst the most attractive performing asset classes - and with some inflation protection. Our logic starts with the view that a buy-and-hold type investment should probably earn its cap rate of roughly five percent, less capital expenditures (which is roughly 14% of net operating income). The net economic cap rate of 4.3% is then compounded at the expected growth rate of income.

Private Infrastructure: Some Exciting Developments Unfolding in this Asset Class Unlike 'traditional' infrastructure of the past, which was synonymous with roads, rail and toll roads, today's infrastructure supports growth sectors like 5G technology with high speed communication towers and data centers, electric vehicles and electrification via new transmission lines and distribution centers, and clean energy initiatives like wind and solar infrastructure. As such, there are certainly several ways to invest in infrastructure, but we are focused on Private Infrastructure where returns are higher and the growth is often faster. In terms of returns, we note that, within the listed infrastructure markets, the observed book value per share growth has been an annualized 5.6%, with valuation at 2.2x book value, return on equity (ROE) at a low of 2.3%, and dividend yield of 3.2%. Assuming a slight multiple compression to 2.0x, ROE normalizing to six percent and dividend yield rising to 3.8%, we have annualized listed infrastructure expected returns of 3.1% over the next five years. Similar to Private Equity and Private Credit, there is a negative relationship between the illiquidity premium and listed market returns. One can see this in Exhibit 39. This relationship is significant, as it implies an illiquidity premium of 4.4% for the asset class, and as such, we forecast annualized private market infrastructure expected returns of 7.5% over the next five years. Importantly, though, we expect there is the opportunity for sizeable differentiation in this asset class (i.e., the spread between top quartile managers and bottom quartile managers is quite high), and we would not be surprised to see top-tier managers deliver almost Private Equity returns in certain instances.

Bonds: A Tougher Road Ahead As we discussed in Section II, the outlook for traditional bonds is challenged, which results in U.S. 10-year returns of close to zero:

• Global Bonds earn a spread above U.S. 10-year yields, which leads to a return of 2.4%
• High Yield has a slightly lower return of two percent as losses are still impacting returns

After updating our forecasted returns for all the various asset classes that we track, we then turned our attention to whether now is actually a good time - given the recent rip upward in liquid markets after the pandemic-induced liquidity surge - to allocate more towards private markets. What we found is that private market asset classes actually tend to perform better as mid-to-late cycle asset classes, which helps to boost their overall performance statistics relative to liquid markets over the life of a fund. One can see this in Exhibit 40. In particular, when public markets returns are less than 15% per year (which is clearly what we are forecasting), then Private Equity as an asset class almost always outperforms Public Equities. In fact, the illiquidity premium actually moves above its 500 basis point historical average to 6-10% when Public Equity market returns are less than 10%. Meanwhile, we also looked at whether investment climate or regime makes a difference in light of our Another Voice thesis calling for a shift in portfolio construction. What we found was encouraging. Specifically, a stronger backdrop for Value, which is consistent with our framework, also tends to foreshadow better returns for Private relative to Public Equities. One can see this in Exhibit 41. This relationship makes sense to us because buyout deals are generally tied to some sort of value-unlocking thesis, so it tracks that the asset class tends to outperform best when markets are rewarding more than just secular growth stories.

The level of interest rates also matters. Specifically, our work shows that the illiquidity premium is also more valuable in today's low rate environment, as its contribution to the overall total return increases as expected returns decline. One can see this in Exhibit 42, which shows the absolute and relative importance of the illiquidity premium in Credit. However, it is not just Private Credit. Our work shows that illiquid investments have performed better than liquid market investments in a low rate environment across a variety of asset classes for several specific reasons. First, investments in the private markets are not passive investments but are actively managed, especially as the importance of operational improvement has grown steadily over time. Second, illiquid markets by definition are not as efficient as they also provide an embedded option on when to buy and when to sell, which is quite valuable relative to the traditional liquid markets. Third, there is often much better alignment between management, investors and shareholders as the ability to have a long-term view and execute on that vision to create value, regardless of the short-term fluctuations in the markets, is a competitive advantage. Thus, it is not surprising in today's environment that more and more companies in the U.S. Tech sector are staying private.

Clients with whom we speak do often share their concerns - or frankly, fears - that the value of the illiquidity premium is being compressed. In particular, they worry about this risk because of increasing flows into the asset class; however, industry data does not yet suggest this concern is one on which to be focused. In fact, buyout dry powder amounts to just 80 basis points of the total public market capitalization, which is actually right about in-line with the long-term average (Exhibit 43). Moreover, as Exhibits 44 and 45 illustrate, Global Private Equity has pretty consistently outperformed Public Equities over time. This outperformance makes sense to us, given that many global public equity markets often lack exposure to key growth verticals. This mismatch of exposure is a big deal, and it creates significant opportunity for portfolio managers who are willing to spend the time needed to create funds that give exposure to the most dynamic sectors in the global economy. Just consider that Indonesia, one of the fastest growth stories in South East Asia, has zero exposure to the Technology sector in its benchmark. In Europe, the Technology sector is just eight percent of the public market index. Hence, the potential for portfolio managers in the Private Equity industry to 'win' through sound portfolio construction, including by ensuring exposure to companies that actually are linked to rising GDP-per-capita stories, is a major differentiator, we believe.

To be sure, the 'story' surrounding private markets' outperformance is not just about index composition. Rather, there is also a significant argument to be made for investing with 'best in class' managers in the alternative space. Indeed, as one can see in Exhibit 48, the delta between the various quartiles is much more significant in the private markets. In a world of lower expected returns, the 'premium' on the ability to garner top quartile returns has - as one might expect - increased significantly.

Our bottom line: We are likely entering a new, more challenging period for expected returns. Equity multiples are high and credit spreads are tight at a time when input costs could degrade margins more than some investors now think. Against the macroeconomic backdrop we envision, we think that all asset allocators will need to do more to embrace volatility as well as to leverage the value of the illiquidity premium across various alternative investments. Government bonds may still play a role in portfolios, but we believe that their effectiveness as both yield enhancers and diversifiers are now somewhat compromised, given such a low starting rate and aggressive monetary/fiscal policy.

Beyond the need to shift asset allocation across portfolios, we also think that there is a significant opportunity to shift stances within portfolios. Specifically, we think we are entering a compelling period for active management in both liquid and illiquid markets. Dispersions are wide within most asset classes, and index composition is poorly skewed towards last decade's winners, many of whom we believe will be laggards this cycle if our thesis remains on track.

Section IV

Conclusion

Pride makes us artificial; humility makes us real. Thomas Merton

As we have detailed in this piece, a strong global recovery is unfolding. It will, however, remain uneven and possibly uncomfortable at times, particularly given the socioeconomic inequalities that have become even more pronounced since the onset of COVID-19. Against this backdrop, now is a time for all, particularly those in the investment management industry, to remember that they are also in the community service business. Humility, focus, and empathy - along with a thoughtful understanding and application of science - are what is needed to make the next chapter a better one.

Against this backdrop, we remain optimistic that continued strong returns in the global capital markets can help. To this end, we forecast that surging earnings growth should more than offset any increase in interest rates that may occur. However, despite favorable near-term conditions, we have likely 'pulled forward' returns, which is consistent with Frances Lim's more muted longer-term forecast. The good news is that three factors - a sturdy illiquidity premium, wide dispersions, and heightened volatility - should give macro professionals and asset allocators the ability to earn returns sufficient to meet their stated obligations. We also think that certain asset classes, particularly collateral-based cash flows, could see a favorable re-rating if we are right about faster nominal GDP growth and higher input costs.

At the moment, real rates are negative 78 basis points, which often coincides with a positive outlook for financial assets at this point in the cycle. However, as we described above, the current level of real rates is actually not that negative relative to history. Moreover, though policy is certainly accommodative, it does not ensure that runaway inflation must occur, we believe. In our view, a major increase in the money multiplier or a dramatic fall in the U.S. dollar will be required to elevate rates in a disorderly way. Said differently, stronger economic growth - in isolation - will not be enough to roil the bond market.

While the current macroeconomic backdrop is complex, and in spite of the many cross currents, we remain highly confident in our Another Voice thesis, a differentiated approach that represents a shift away from the secular growth bull market that dominated the prior decade. To be sure, we are not advocating that portfolio managers own only cyclical exposure; but we do think that the combination of looser monetary and fiscal policy, faster nominal GDP growth, and accommodative financial conditions argues that there is opportunity in pursuing themes beyond just digitalization and e-commerce. Chunkier allocations to our key themes, including nesting, resiliency, and savings all make sense to us. And as part of our diversification effort, we would also continue to increase exposure to Infrastructure, Asset-Based Finance, Real Estate Credit, and value-added Private Equity (e.g., corporate carve-outs). Equities too make sense, as our bottom line continues to be that we must create portfolios that will thrive as politicians and central bankers test the limits of reflation.

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