Mile 18 of a marathon market cycle: expect low returns to the finish

With financial markets already inflated by years of easy monetary policy, investors drove asset prices even higher from U.S. Election Day through the first half of 2017, riding a wave of renewed confidence reinforced by strong corporate earnings.

Inflation expectations and yields on 10-year U.S. Treasury notes initially rose-and then fell-as market participants assessed whether the economic agenda favored by the new administration would be realistic and sustainable.

While much of the good news may already be priced in, we think the current U.S. economic expansion, already among the longest on record, is likely to continue for a while longer. Putting our view in marathon terms, we're near mile 18 of a 26-mile market cycle-a long way from the start, with forward momentum still intact, but some sore spots starting to emerge. For most domestic asset classes, we expect low returns from here to the finish line.

Our half-return world narrative, in which prospective returns for most financial markets represent roughly half their long-run historical averages, remains in place. While both equity and fixed-income markets are likely to deliver structurally low returns for an extended period, we're more favorably inclined toward equities. We believe a combination of low rates and low inflation should keep most stock market valuations relatively stable, even at these elevated levels. That's not to dismiss the rising risks of a garden-variety correction in the coming months, particularly for an expensive U.S. equity market.

Regarding economic fundamentals, U.S. consumers have turned uncharacteristically cost conscious and savings oriented. Atypical of the fast spending of baby boomers' earlier years, the growing proportion of retirees seems to be spending less, which appears to have hurt auto sales, among other things.

Meanwhile, the U.S. unemployment rate hovers near its post-crisis low, but the growth of U.S. tax receipts from individuals has fallen to zero, a sign that incremental working hours are not translating into increases in taxable income. Part of the explanation for this tax receipt and spending anomaly may reside in the disproportionate share of job growth in lower-wage sectors.

On balance, what are the implications for asset allocators? Global diversification, with representation across asset classes around the world, remains our aim. Emerging-market equities offer some of the best return prospects for long-term investors comfortable with their risks, while developed-market sovereign bonds yielding less than zero offer some of the worst. Our views for most other assets stand somewhere in between.

Our estimates show that global emerging-market equities have some of the best return expectations over the next five years. We believe valuations for the asset class continue to look attractive, and there's a lot of growth momentum there, as well.However, these expected returns are not without commensurate risks, and it's important to note that there's a wide divergence across different regions and countries.

The biggest caveat is the potential for renewed U.S. dollar strength, which typically tightens financial conditions in developing economies. Moreover, if trade barriers rise across the world through escalating protectionist policies, it could leave certain emerging-market economies vulnerable.

On the whole, we expect fixed income to deliver muted returns relative to the historical norm. Current yields, which remain low, are generally the best predictors of expected long-run returns for bonds, and we believe returns over the next decade will closely mirror prevailing interest rates.

U.S. investment-grade core bond returns are likely to remain near the 1% to 2% range-and in most cases, we don't see the potential for returns of much more. Prospects for developed-market sovereign bonds issued outside the United States, some of which yield less than zero, look even less attractive.

In our view, emerging-market debt offers some of the best value among the world's bond asset classes. Emerging-market debt coupons are relatively high, and default rates remain low, with stabilizing currencies and continued central bank accommodation providing additional support.