CONTRIBUTORS
Max Gokhman, CFA
Deputy Chief Investment Officer
Franklin Templeton Investment Solutions
Tom Nelson, CFA, CAIA
Head of Market Strategy
Franklin Templeton Investment Solutions
Miles Sampson, CFA
Head of Asset Allocation Research,
Franklin Templeton Investment Solutions
About capital market expectations (CMEs)
Every year, we review the data that drive capital markets—current valuation measures, historical risk premia, and economic growth and inflation prospects—to provide the foundation for our forecasts. We update the models that we use and review their continued appropriateness. Crucially, our models are based on first-principle economic relationships and reflect seasoned practitioner judgment.
We continue to include as part of every capital market forecast a measure of the expected volatility of each asset class, informed by both long-term and short-term volatility dynamics. By incorporating a blend of structural and cyclical inputs, our forward-looking estimates for volatility and correlations avoid undue recency bias while allowing for tactical adjustments when market conditions shift. This balanced approach provides a more robust foundation for our capital market assumptions across varying regimes.
Our CMEs are designed to provide annualized return expectations over a longer-term horizon, typically viewed as 10 years. Specifically, we calculate geometric-mean return expectations over a 10-year period, a method which both fully captures the average length of a US business cycle and aligns with the strategic planning horizon of many institutional investors.1
Our modeling approach is based on a blend of objective inputs, quantitative analysis and fundamental research, consistent with the skill set of our Franklin Templeton Investment Solutions (FTIS) business. Underpinning these inputs are assumptions on the sustained growth rates that developed and emerging economies can expect to achieve and the level of price inflation they will likely experience. This approach is forward-looking, rather than being based on historical average returns. This is especially important in an evolving macroeconomic environment.
Summary
We believe allocators should brace for relatively lower portfolio returns across the next decade, against a background of historically elevated equity valuations, high profit margins and narrow credit spreads. Core fixed income will play a central role in portfolios amid positive real yields and higher term premia notwithstanding troubling fiscal deficits for some developed economies. Against this backdrop, private markets are expected to become more important as a source of diversification and return enhancement.
- Equities remain a key conduit for participating in global productivity growth and innovation, while also offering a partial long-term hedge against inflation through nominal revenue expansion and pricing power in select sectors.
- Investors may benefit from a subtle rebalancing toward international developed markets and select emerging economies, where starting valuations are more reasonable and earnings growth remains attractive.
- Cash retains its role as a liquidity sleeve and short-term inflation buffer, but as curves re-steepen and term premia normalize, extensions in duration are likely to outperform cash over our 10-year horizon.
- Corporate yield spreads across both investment-grade and high-yield segments remain well below their long-term mean, diminishing the appeal of carry and reducing compensation for taking on liquidity risk.
- Private equity and credit can assist with return enhancement to help offset lower expected public market performance. Over long windows, top-tier private equity managers have outperformed public benchmarks.
- Real assets are likely to play a crucial role in portfolios, particularly if our view of increased inflation pressures materializes.
- We expect the US dollar to depreciate modestly over a longer horizon, reflecting a rich starting valuation and a gradual narrowing of the US growth and interest-rate advantage relative to the rest of the world.
Endnote
1. Since 1945, the National Bureau of Economic Research has defined 12 US business cycles, with an average duration of 75 months.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
To the extent the fund invests in alternative strategies, it may be exposed to potentially significant fluctuations in value.
The allocation of assets among different strategies, asset classes and investments may not prove beneficial or produce the desired results. To the extent a strategy invests in companies in a specific country or region, it may experience greater volatility than a strategy that is more broadly diversified geographically.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. The government’s participation in the economy is still high and, therefore, investments in China will be subject to larger regulatory risk levels compared to many other countries.
Currency management strategies could result in losses to the fund if currencies do not perform as expected.
Active management does not ensure gains or protect against market declines.
An investment in private market investments is suitable only for investors who can bear the risks associated with them (such as private credit and private equity) with potential limited liquidity. Shares will not be listed on a public exchange, and no secondary market is expected to develop.
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