Capital Market Expectations

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.

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 capital market expectations 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 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.