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1/31/2025
The return outlook for the next decade
Jason Chen
Senior Portfolio Strategist
Christian Scherrmann
U.S. Economist
Dirk Schlüter
Co-Head, DWS House of Data
The return outlook for the next decade
After over two years of tight monetary policy, the Fed started cutting interest rates in September of 2024 in an effort to provide a more accommodative backdrop for the economy. According to Fed Chairman Jerome Powell, the focus of the Fed going forward would shift toward support a healthy labor market as inflationary fears appear to be mostly in the rear view. While services inflation remains above the Fed’s 2% target inflation level, supply chain-related order backlog issues have eased since the pandemic. Inflation has slowed to where the Fed has begun cutting rates, but government bond yields in real terms remain at the higher end of the post-Global Financial Crisis (“GFC”) range. The move higher in interest rates across the US Treasury curve continues to apply a higher real interest burden for longer-term borrowers, and the Fed continues to allow its balance sheet to gradually shrink through Quantitative Tightening (“QT”) measures first enacted in May of 2022. Beyond economic borrowers, real interest expense for government debt is also higher than it has been in some time, reintroducing questions around the sustainability of ballooning sovereign debt balances across developed economies.
Despite this prolonged period of monetary tightening—with the highest real US Treasury yields in over a decade and an inverted 10yr-2yr yield curve, the US and global economies have been stubbornly resilient, avoiding any material slowdown in economic growth, and maintaining tight labor markets. The resilience in the macroeconomy over this period has raised questions about whether the effectiveness of monetary policy measures on the real economy has been fundamentally altered. Some economists and investors now believe that the composition of the global economy as well as the structure of borrowing has changed the reaction function of businesses and individuals to central bank policy. Should the transmission mechanism between monetary policy and financial conditions be “broken” in some form, traditional relationships between rates and growth or between rates and risk premia would require rethinking both by policy makers and by policy takers (both borrowers and investors).
Do we believe that monetary policy has lost its potency? In short, no. Shifting dynamics in fixed versus floating rate borrowing, marginally higher sensitivity of debt costs to liquidity and market conditions over interest rates, the increasing use of off-balance sheet private lending channels, and the gradual moderation from an overly tight labor market help to explain, in our view, the more gradual impact of elevated interest rates on the economy that we are seeing signs of in recent quarters.
Heading into the end of 2024, our return forecasts are modestly lower versus the beginning of the year. After three quarters of strongly positive risk-asset returns, valuations across equity and credit have continued to become even more demanding from already historically elevated levels, reflecting tremendous optimism around the potential for artificial intelligence to materially improve economic growth and productivity. For higher quality and sovereign bonds, our 10-year return outlook appears modestly lower relative to the beginning of the year, reflecting slightly lower starting yield levels.
In aggregate, our nominal return forecasts across most asset classes are lower relative to the start of the year. Strong returns across risk assets and a modest rally in sovereign bond yields has manifested in a much flatter forward-looking efficient frontier and leaves the strategic return outlook across asset classes at much more modest levels relative to the end of 2023.
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