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Capital Market Assumptions: Global Equities in Focus

With all that's going on in the world right now, the constant news flow, twittering and tariffing, recession obsession, and of course a little extra market volatility here and there, it might seem strange for me to write about what is a somewhat obscure and long-term focused topic.

But if anything, now is probably a great time to actually tune-down the noise levels a bit and briefly press pause on the urgency of the short-term and spend a little time thinking about the medium-longer term outlook across asset classes.

While I will make reference to other asset classes, I'm going to focus on global equities because I think that's where the most interesting opportunities are, and where perhaps some of the biggest misconceptions and opportunity for misunderstanding lies.

On with the first chart. This one might be familiar for regular readers, it provides an extract of the expected returns for some of the key asset classes (from a USD perspective).

I would say there will most likely be some disagreement with my analysis in terms of the absolute levels, but I think most people who have done any work on this will agree broadly with the relativities (which when it comes to portfolio construction is perhaps the most important issue).

Basically, treasuries are expected to deliver the worst return over the long term (low yields = low returns). Cash is next worst ... I would expect some will probably proffer that the cash rate forecast should be much lower or even negative, but we need to be careful about mixing the cyclical view with the long-term forecasts.

Cash rates will almost certainly go lower short-term, but I would caution against putting too much weight in the punditry - more often than not they are merely extrapolating current conditions/recent trends out to eternity, and they often shout the loudest when things are at an extreme, so you can get fooled by these suspects into thinking that a cyclical condition is a permanent fixture.

Moving on, perhaps the most important point is that "equities" are expected to outperform 'safe' fixed income over the medium-long term. Another way of saying this is that the equity risk premium [ERP] is positive (and I run a number of measures of the ERP, all are positive, and for the most part have risen materially over the past year as valuations have broadly not moved a great deal and bond yields have collapsed).

Within equities, the US is expected to deliver positive returns over the medium-longer term, but global ex-US (emerging markets and developed excluding US) is expected to substantially outperform US. And this is probably where the most misunderstandings, misconceptions, and mix-ups can be found. The other thing is, it is where the largest return spread can be found in that chart, so it makes sense to look at this in further detail.

So first stop is to breakout global equity expected returns into its key components (at least within the framework that I use). The chart below shows the 4 key components of longer term expected returns for US equities, Developed Markets excluding US, and Emerging Markets (the same as in the first chart), but also shows ACWI (All Countries World Index - i.e. global), and Frontier Markets.

So let's go through the key differences and then look at some of the trends and rationale. First, you can see the US has the lowest dividend yield (let's set aside the issue of the buyback yield for now), but the biggest thing is the US has a large expected negative contribution from valuation, whereas global ex-US is expected to have a positive contribution from valuation changes. Expected growth varies: the US is middle of the pack, developed ex-US is lower, and EM/FM are higher. Expected hedging premium (discount) is positive for developed ex-US, and negative for EM/FM.

That's a relatively short paragraph, but there is a lot to unpack. Probably also some controversy!

Dividend Yield

As far as I'm concerned expected returns should always start with dividend yields. Dividends are typically a stable and significant contributor to total returns over the longer term. The chart below shows the contribution of price vs dividends to total returns over the past 25 and 10 years for the major chunks of global equities.