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Éric Morin, CIBC Asset Management, senior analyst.
So first, the big returns that we saw last year in 2020 and in the recent months as well, were driven by transitory factors. So, big returns last year were driven by the big plunge of economic activity and were more recently boosted by the positive development regarding vaccination and the vaccine. Big returns last year were also boosted by the introduction of a new policy regime in which inflation is now seen as the problem and fiscal policy the solution to support the recovery. So, this new regime and the development on the vaccine front was a big positive for markets. And this resulted in bigger returns that we should not expect this year. One of the reasons why returns will be also more normal this year is the fact that equity valuation is not cheap anymore, as it was last year, following this part of the pandemic.
What should we expect in upcoming years? We should expect definitively more modest return. Keep in mind, however, that typical macro forces should remain an important cyclical tailwind for equity overall in the next few years. And this is because the economy is still far away from an excess demand or overheating, if you will. That’s the first reason. And the second reason is that fiscal policy will remain growth friendly, supported by central banks’ actions and low trend inflation.
So as a result, and despite the evaluation that is not cheap anymore, we expect most equity asset classes to deliver at least 5% of return, on average, in the next 10 years. That’s part of the long-term expected return exercise we do every year. And the prospects are the most appealing in emerging Asia and emerging Europe at about 9% on average, and Canada and Europe are trailing not far behind with expected returns of about 6 to 7%.
While most equity asset classes will offer appealing returns in the next 10 years — so returns of at least 5% — prospects are more subdued in the U.S. They are below 5%. And the main reason for that is that valuation is expensive. One of the key factors that equity investors will have to look at is that we should expect more volatility and cross-country heterogeneity looking ahead, as the recovery and the global reopening won’t follow a linear path. So, we should expect more volatility. Another reason for that is that inflation could become as well more volatile. And also investors could start to question the new policy regime. So, if anything, like for fixed income, it will be important for investors to have good diversification in the portfolio. And I refer to geographical diversification as well as sectoral diversification.
So, we should expect three things about inflation in the next 10 years. In the near term, we should expect inflation to move higher and to be more volatile because of transitory factors such as strong demand in a context of low inventories, a shortage of semiconductors, for example, higher oil prices. So, in the near term, investors should expect higher inflation. However, this inflation, this trend of inflation, will be seen by central banks as being transitory. Trend inflation should remain low over the course of the next 10 years. And when I refer to trend inflation, it means that central banks will look at core inflation, excluding idiosyncratic/volatile factors.
And so, trend inflation will remain low for three reasons. The first one is that the relative cost of capital compared to labour has continued to decline since 2015. So, it’s increasingly less expensive to invest in capital rather than hire people.
The other reason, which is also microeconomic, is that it’s increasingly possible to replace workers by machines, let’s say. So, the elasticity of substitution has increased over time. The fourth reason is that the Phillips curve, which is the relationship between the output gap of an economy with inflation — the Phillips curve, the coefficient has declined over time, which means that inflation is, in the case where the economy will eventually overheat, we should expect less inflationary pressure from the economy, as the relationship between excess demand and inflation has declined over time.
Another reason is that most countries should expect further aging of their population, and globally and historically, this has been associated with the lower inflation.
The main implication of low inflation is that central banks will remain comfortable to keep interest rates low over the long run. And this will support a fiscal policy stance that will remain growth friendly, and this will provide a tailwind for equity.