ANALYSIS ANALYSIS ANALYSIS ANALYSIS Above the Noise 10-YEAR CAPITAL MARKET ASSUMPTIONS 2025 INVESTMENT INSTITUTE FOR INSTITUTIONAL, PROFESSIONAL, QUALIFIED INVESTORS & QUALIFIED CLIENTS ONLY. FOR GENERAL PUBLIC DISTRIBUTION IN THE US ONLY.
CONTENTS INTRODUCTION 3 01 A TIME-TESTED APPROACH 5 02 THEMES TO WATCH FOR THE NEXT DECADE 8 03 EQUITY 23 04 FIXED INCOME 29 05 ALTERNATIVES 35 06 CURRENCY 38 07 VOLATILITY & CORRELATION 42 08 THE IMPORTANCE OF CAPITAL MARKET ASSUMPTIONS 44
3 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Annually, the BNY Investment Institute develops capital market assumptions for approximately 50 asset classes spanning global markets. The assumptions are based on a 10-year investment horizon and are available in terms of the US dollar, British pound, Japanese yen, and euro. Our assumptions are meant to guide investors in developing long-term strategic asset allocations. OVERVIEW So far in 2024, we have enjoyed healthy equity performance as markets successfully navigated a directional shift in monetary policy. The battle between central banks and inflation has reached its inflection point; inflation is now seemingly on the retreat at the expense of cooling the global economy. As we look ahead to 2025, the stage is set for a series of additional rate cuts, looser financial conditions, and the launch of a new phase of growth. We anticipate continued macroeconomic uncertainty in 2025. The key question is whether markets will perceive future rate cuts as stabilizing actions or emergency measures. If the US Federal Reserve (Fed) delays action, the lagged effects of tighter conditions and political instability could pressure the US economy into a shallow recession. Nonetheless, our base case is that the US economy will slow to below-trend growth while avoiding outright recession as inflation declines to target levels. We may also see labor productivity accelerate from hastening the adoption of artificial intelligence (AI), propping up revenues and keeping corporate margins healthy. Taking everything into account, 2025 is expected to be a transitional year for the economy with potential opportunities for investors.
4 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. KEY TAKEAWAYS EXHIBIT O1 2025 vs. 2024 Capital Market Return Assumptions • Businesses that integrate AI early are more likely to increase their profitability through higher worker productivity. Our assumptions reflect higher earnings growth in US equity markets as the US is likely to be the most rapid adopter of innovative AI technology. • As the easing cycle progresses, the opportunity to lengthen duration is fading. We forecast US Treasury bills to earn a 1.1% real return over the next decade, while US Treasury markets are projected to achieve 2.2%. • For US investors, we anticipate the highest fixed income returns will come from domestic bond allocations. We expect international allocations to earn higher returns when their currency exposure is hedged. We think investors should consider hedging international bond allocations this year to help maximize risk-adjusted returns. • The latest market fluctuations underscore the importance of diversified portfolios in withstanding market volatility. We believe alternatives may offer more diversification if the correlation between stocks and bonds remains elevated. Expected Return 2025 Expected Return 2024 Standard Deviation 2025 EQUITY We anticipate a modest improvement in equity earnings growth as the adoption of AI enhances worker productivity and improves corporate profitability. 7.5% 7.4% 16.2% US Equity 6.7% 6.3% 16.3% Non-US Developed 7.7% 7.3% 18.7% Emerging Markets FIXED INCOME The current level of yields, combined with the global trajectory of monetary policy, enhances the attractiveness of fixed income markets at this entry point. 4.8% 4.8% 5.1% US Aggregate 6.0% 5.8% 8.4% US High Yield 3.2% 2.5% 8.3% Global Agg. Ex-US 4.0% 2.9% 9.0% EM Local Currency ALTERNATIVES Alternative asset class expected returns are in line with publicly traded markets on a risk-adjusted basis with additional return opportunities for alpha and compensation for illiquidity. 4.5% 5.0% 4.6% Absolute Return 5.3% 5.5% 6.3% Hedge Funds 9.7% 8.8% 20.1% US Private Equity Source: BNY Mellon Advisors, Inc. (BNY Advisors) as of November 2024.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 5 01 A TIME-TESTED APPROACH THAT APPROXIMATES REAL WORLD RESULTS
6 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. For years, BNY has developed capital market assumptions to assist our clients in designing their long-term asset allocations. We believe it is essential to compare forward-looking return expectations against actual market returns. We consistently review and assess the accuracy of our assumptions to refine and enhance our methodology. Evaluating our 10-year assumptions from 2015 reveals that our expectations for US large-cap equities were too low, while mid- and small-cap equities were approximately in line. Projections for international and emerging market equities were overly optimistic, and fixed income expectations were slightly too high. While we explore the root causes of these deviations, we should highlight the accuracy of the projection for a hypothetical strategic asset allocation (SAA), shown at the far right of the Exhibit. The accuracy of the SAA’s assumption was only surpassed by one asset class and demonstrates the value of a balanced asset allocation. Accurately forecasting a 10-year return for any market is beyond challenging, but the return of a well-diversified portfolio has proven to be more predictable over the long term. We believe this result highlights the importance of our assumptions in their application to portfolio construction. EXHIBIT TTA1 2015 Capital Market Assumptions vs. Actual 10-Year Returns Sources: BNY Advisors, Bloomberg. Data as of June 30, 2024. Note: Strategic Asset Allocation represents a hypothetical portfolio with weights of 20% US Large Cap Equity, 7% US Mid Cap Equity, 3% US Small Cap Equity, 16% International Developed Equity, 7% Emerging Markets Equity, 2% US REIT, 25% US Aggregate Fixed Income, 5% US High Yield, and 15% Hedge Funds. 7.3 8.0 8.4 7.0 9.0 7.5 2.7 4.8 4.8 5.8 12.5 9.0 7.0 4.3 3.2 6.1 1.3 4.3 4.8 5.7 -5 0 5 10 15 20 25 US Large Cap Equity US Mid Cap Equity US Small Cap Equity Int Developed Equity Emerging Markets Equity US REIT US Aggregate US High Yield Hedge Funds Balanced Portfolio +2 Standard Deviations Actual 10-Year Return 2015 Expected Return -2 Standard Deviations 01 | A TIME-TESTED APPROACH
7 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. In our analysis of where our forecasts deviated materially, we explored why large-cap companies have outperformed small-cap companies. We attribute their divergent performance to valuations and profitability. These factors lifted the annualized returns of large cap to over 12% but had otherwise flat impacts on small-cap equities. The strongest evidence supporting a small-cap premium is that smaller firms achieved higher revenue growth than larger ones. We see little evidence supporting the persistence of any previously mentioned trends and believe some have potential to reverse. For this year, we estimate a small-cap premium of 0.5%, which is about half the premium projected in 2015. EXHIBIT TTA2 Annualized Percentage Change in US Equity Fundamentals 2014–2024 Sources: BNY Advisors, Bloomberg. Data as of June 30, 2024. While international and emerging market equities underperformed expectations, realized returns fell within one standard deviation of our assumptions. Reflecting on our 2015 building block framework, our projections of inflation, dividends, and buyback yields proved the most accurate, whereas our expectations of real earnings growth did not materialize. Lower-than-expected valuations further compounded underperformance in emerging markets. In fixed income markets, the returns of US Aggregate bonds fell short of expectations despite our accurate forecast of the US 10-year Treasury yield. The ending yield was 4.4%, just 0.1% above our projection. The primary reason for the underperformance of US Aggregate bonds is due to a much later rise in yields than anticipated. This caused bonds to be repriced later than expected and led to less income over time. US High Yield bonds fell below expectations for similar reasons, though shorter duration helped mitigate repricing losses. 7.3 3.2 5.1 2.1 5.9 -0.7 5.7 0.2 Earnings Valuations Revenue Profit Margin US Large Cap US Small Cap 01 | A TIME-TESTED APPROACH
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 8 02 THEMES TO WATCH FOR THE NEXT DECADE We acknowledge that a multitude of short- and long-term themes and trends will shape capital markets in the coming decade. The extent to which these themes affect our investments is inherently uncertain and underscores the importance of a well-designed portfolio strategy. Here, we highlight the key themes we believe will have a significant influence on markets over the next 10 years.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 9 THEMES STOCK-BOND CORRELATION 10 The elevated stock-bond correlation is likely to normalize as the economy continues to stabilize. However, increasing concerns about debt sustainability could lead to steeper and more volatile yield curves with less diversification from equity markets. THE SECOND WAVE OF ARTIFICIAL INTELLIGENCE 14 The continued adoption of AI will have more widespread impacts beyond semiconductor manufacturing and electric industries. AI has potential to boost productivity in corporate sectors leading to higher revenue generation and cost savings. DEGLOBALIZING EMERGING MARKETS 17 The Emerging Markets Equity growth premium is not what it used to be. China is trying to reflate and boost equity market sentiment, but it faces long-term economic challenges and increasing protectionist measures. Despite this, its shift to advanced manufacturing and India’s positive outlook offers opportunities for real growth. SHIFTING GEARS IN PRIVATE CREDIT 19 Demand for alternative financing away from traditional banks has led to a rapid rise in the private debt industry. The market offers attractive yields for income investors although it is facing several near-term challenges, which could compress private credit yields toward the US high yield market. CLIMATE RISK & RESILIENCE 21 With 2024 on track to be the hottest year on record, global policymakers have worked to address physical and transition climate risks. The ability to navigate these risks is critical to building market resiliency and implementing scalable, sustainable solutions.
10 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. STOCK-BOND CORRELATION Diversification is a core principle of portfolio management reflected through our correlation assumptions. Therefore, the correlation between stocks and bonds should be carefully studied when designing a strategic asset allocation. In Exhibit SBC1, we display the efficient frontier of a two-asset portfolio consisting of US equities and US Treasuries under multiple correlation assumptions. The key finding is that a positive correlation increases the volatility of all portfolios, but more worryingly, it raises the volatility of defensive portfolios more than aggressive ones. We assume a slightly positive level for the long-term stock-bond correlation and we think investors with low-to-medium risk tolerances should consider allocating a greater share of their portfolios to alternative asset classes for additional diversification. EXHIBIT SBC1 Efficient Frontier Under Multiple Stock-Bond Correlation (SBC) Assumptions Source: BNY Advisors as of November 2024. 4 5 6 7 8 2 6 10 14 18 Expected Return (%) Volatility (%) Stock-Bond Correlation = 0.5 Stock-Bond Correlation = 0.0 Stock-Bond Correlation = -0.5 02 | THEMES TO WATCH
11 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. A negative stock-bond correlation has benefited traditional portfolios for over 20 years, but as shown in Exhibit SBC2, this trend has sharply reversed. The exhibit traces the correlation from the 1970s and suggests that a reasonable assumption would be approximately zero, although few periods reflect this outcome. A helpful way to understand changes in the stock-bond correlation is to examine the influence of supply and demand shocks on growth, inflation, monetary policy, and their subsequent impacts on financial markets. The following section will provide a brief outline of what economic shocks mean for markets, particularly how they shape the comovement between stocks, bonds, and alternative asset classes. We have chosen to include growth and inflation alongside our asset class forecasts this year; Exhibit SBC3 provides a subset of their assumptions. A demand shock refers to an unexpected change in the demand for goods and services in the economy. A positive demand shock occurs when demand increases unexpectedly (e.g., due to fiscal policy), typically resulting in greater utilization of resources and, in turn, greater price pressures. Equity markets rise in this environment as earnings expectations are revised higher, while bond prices fall, in line with expectations for more restrictive monetary 02 | THEMES TO WATCH policy. The opposite holds true in a negative demand shock, where demand and inflation fall together, weighing on equity markets but lifting bond prices. This dynamic, where growth and inflation move in similar directions, is a fundamental trait of demand shocks and leads to negatively correlated equity and bond markets. As demand shocks were the prevalent driver of the global economy from 2000 through 2022, the stock-bond correlation was consistently negative over the period. A supply shock refers to an unexpected change in the supply of goods and services in the economy and is associated with growth and inflation moving in opposite directions. A negative supply shock occurs when there is a decrease in the availability of goods or services in the economy, the decline in output then shocks inflation sharply higher. Growth is further stifled if tighter monetary policy is required to reduce inflation. Both equity and bond markets sell off in this environment, as they did in 2022, causing a nasty correlation on the way down. 2022 was the year when the stock-bond correlation began a rapid ascension upward, driven by significant supply chain challenges related to semiconductor shortages, China’s zeroCovid policy, and the Russia-Ukraine conflict’s impact on energy and agricultural markets. Inflation rose to levels not seen since the 1980s and leading economic indicators fell sharply over the year. EXHIBIT SBC2 Rolling 3-Year S&P 500®/US Treasury Correlation Sources: BNY Advisors, Bloomberg. Data as of June 30, 2024. Note: 12-month moving average of a rolling 3-year correlation (S&P 500® Index vs. Bloomberg US Treasury Index). -1.0 -0.5 0.0 0.5 1.0 '76 '80 '84 '88 '92 '96 '00 '04 '08 '12 '16 '20 '24
12 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. When economies experience supply shocks, alternative markets have historically served as a ballast to portfolios. Assets that hedge against supply shocks are those with a positive correlation to inflation, offering diversification and inflation mitigation at just the moment when the stock-bond correlation rises. During 2022, commodities and natural resources were among the few asset classes to achieve positive returns, while infrastructure allocations remained flat. In contrast, both equity and bond markets declined by over 10%. We expect these alternative asset classes to play larger roles in diversified asset allocations over the next decade due to their defensive inflation sensitivity. We expect the stock-bond correlation to average slightly above zero over the next ten years, contrasting the two decades before Covid. In our view, as the world undergoes several structural transitions — ranging from the AI-related technological disruption and its effect on productivity, decarbonization and its impact on energy markets, geopolitics and the reconfiguration of supply chains, to demographics and a decline in the global labor force — the supply side of the global economy will become more volatile, with supply shocks becoming more frequent. EXHIBIT SBC3 Asset Class Correlations to Growth and Inflation US Growth US Inflation US Equity 0.19 -0.01 US Treasury -0.11 -0.32 Commodities 0.29 0.27 Global Natural Resources Equity 0.15 0.11 Global Listed Infrastructure 0.23 0.04 Absolute Return 0.33 0.09 Hedge Funds 0.32 0.06 Sources: BNY Advisors, US Conference Board, US Bureau of Labor Statistics, Bloomberg. Data as of June 30, 2024. 02 | THEMES TO WATCH
13 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. In addition, we see the potential for an increase in the credit risk of fixed income assets, which would also push up on the correlation with equity markets. Global debt-to-gross domestic product (GDP) ratios have been deteriorating in most economies, as shown in Exhibit SBC4, and the International Monetary Fund (IMF) projects a continued worsening of debt sustainability. In the absence of large fiscal adjustments, we may see greater bond market activism steepening yield curves globally, pushing both the volatility of sovereign bond markets and their correlation to equity markets higher. EXHIBIT SBC4 Debt Burdens Are Growing Globally Sources: BNY Advisors, IMF Global Debt Database, Bloomberg. Data as of November 30, 2024. 15.3 14.7 12.9 2.4 2.8 20.0 27.0 11.7 9.0 4.5 -6.6 7.6 -0.6 26.4 -10 0 10 20 30 40 50 60 United States United Kingdom France Germany Italy Japan China Increase in Debt-to-GDP (%) 2023 to 2029 (IMF Forecast) 2018 to 2023 The debt burden of the United States was brought somewhat into question late in 2023 as Fitch Ratings issued the second downgrade of United States debt, pushing Treasury yields to decade highs. The rating cited concerns over the deteriorating fiscal outlook and a governance structure that prevents the country from addressing medium-term issues such as Social Security and rising health care costs. Further bond market activism was seen in France, as spreads of French OATs1 to German Bunds widened in June 2024 following the country’s snap elections. Fear that the second largest economy in Europe would be unable to adhere to the fiscal rules of the European Union have now become top of mind for investors. 02 | THEMES TO WATCH
14 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THE SECOND WAVE OF ARTIFICIAL INTELLIGENCE AI and Generative AI in particular, could represent an important technological innovation for the global economy. 02 | THEMES TO WATCH Generative AI can be used in several use cases across almost every industry as it can create new, original outputs (e.g., content) based on patterns it learned during its training. It’s a General-Purpose Technology (GPT). Like steam internal combustion engines, electrification and computers, it could fundamentally reshape industrial organization and the world of work; and stimulates the development of complementary technologies. It is extremely hard to predict exactly how AI will develop, but we think it will have a large, direct impact on a range of industries and job functions. AI is both labor saving (e.g., autonomous vehicles), and labor augmenting (e.g., demand prediction). In extremes, it could be a viable substitute for all current human cognitive functions. Artificial intelligence (and robotization — i.e., machines controlled by computers) are not “new” innovations, so why should they start lifting productivity growth soon? Innovations can be subject to a J-curve before they boost productivity, where its impact is absent or low for some time but eventually accelerates exponentially. At the macro level, the J-curve framework is consistent with the marked slowdown in productivity growth over the previous decade but now points toward a surge in productivity over the near horizon. Further, the adoption of artificial intelligence must be accompanied by data centers and semiconductor plants to support its global use. Exhibit AI1 shows the percentage change in investments for research and development (R&D) and capital expenditures (capex), highlighting US leadership and facilitating earlier AI adoption compared to other countries. EXHIBIT AI1 Percent Change in Capex & R&D from 2018 to 2023 Sources: BNY Advisors, Bloomberg. Data as of November 30, 2024. Russell 3000 MSCI World Ex USA MSCI Emerging Markets -9.1% -1.3% 30.8% 45.3% 21.1% 94.2% Investment in R&D Capital Expenditures
15 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. History has demonstrated that technological revolutions come in two broad phases. During the first phase, technology is developed and rolled out to the rest of the economy, with benefits mostly accruing to firms that are directly involved in related activities. The next phase is adoption, where the technology then spreads into the economy and drives productivity growth, benefiting firms not directly involved with the technology’s development. Artificial intelligence has been around for some time and is now transitioning toward the second phase. We present Exhibits AI2 and AI3 to highlight recent adoption trends within US business. It is unsurprising to find technology firms adopting AI so quickly, but we note the broader theme — AI adoption and use cases heavily favor cognitive labor compared to physical labor. AI technology is now assisting marketing specialists with content generation and virtual chat agents are helping developers accelerate software development cycles. Further analysis reveals that smaller firms are adopting artificial intelligence faster than larger ones. Additionally, smaller firms who adopt AI appear to be associated with higher levels of revenue growth. Adoption rates are still low in the construction and manufacturing sectors. We think this is because implementing robotics automation demands significant capital investment, with potential for consumers to benefit from the related cost savings rather than firms. We anticipate AI’s manifestation within the economy over the next decade but, considering recent adoption rates, not for at least another two to three years. 02 | THEMES TO WATCH EXHIBIT AI2 & AI3 Reported Use Case of AI Within Business Construction Manufacturing Real Estate Leasing Educational Services Finance & Insurance Technical Services Information 18.0% 12.0% 6.5% 9.0% 8.0% 2.5% 1.0% 21.0% 15.0% 10.5% 10.0% 9.0% 4.0% 1.5% Expected AI Use Current AI Use Reported AI Use Cases Robotics Automation AI Decision Making Systems Machine Learning Speech Recognition Data Analytics Virtual Agents Marketing Automation 28.4% 21.6% 17.0% 15.9% 13.6% 5.7% 3.4% 36.5% 28.2% 23.0% 22.2% 22.1% 14.1% 3.8% Expected AI Use Current AI Use Sources: BNY Advisors as of November 2024. US Census Bureau. Business Trends Outlook Survey, Artificial Intelligence Supplement.
16 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Whether AI will be beneficial or disruptive for any industry, will depend on (1) the degree to which AI is productivity-enhancing and (2) the new competitive dynamics created by the spread of AI. Industries where the impact of AI will be significant and competitive dynamics high are most prone to disruption. Prices and profit margins are likely to decline and added value will be progressively captured by the consumer. In contrast, industries where the impact of AI on productivity will be high and competitive dynamics low are expected to benefit the most, as additional value created is retained by the firm. We illustrate these dynamics within Exhibit AI4. It is important to note that a fall in prices could lead to a rise in demand, lifting revenues. Thus, even if profit margins decline, corporate earnings may still benefit from disruptive technology.2 02 | THEMES TO WATCH As noted, we have adjusted our assumptions of equity earnings growth according to this thematic report. Our adjustments considered which regional markets have the largest potential for value creation, according to exhibit AI4, and how quickly AI is likely to be adopted within these regions. In aggregate, these adjustments provide a boost to corporate earnings through improved profit margins. We anticipate developed markets will have more opportunities for value creation due to higher exposure to software and pharmaceuticals industries. Further, innovative technology is likely to be more accessible within developed markets given higher investments in R&D and infrastructure investment. Dynamic economies, such as the United States, are particularly likely to benefit from AI due to higher adoption rates within innovation hubs. Data privacy and content regulations in Europe may hinder AI adoption. We do not expect emerging markets to benefit as greatly over the next 10 years given the lower readiness to adopt and diffuse AI in the economy, and the higher share of GDP that is driven by sectors where manual tasks are prevalent. EXHIBIT AI4 AI Dynamics INDUSTRY COMPETITION PRODUCTIVITY IMPACT HIGH LOW HIGH Prone to Disruption (Consumer Captured) Poised to Benefit (Firm Capture) LOW Low Value Creation (Consumer Captured) Minimal Impact Source: BNY Advisors as of November 2024.
17 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. DEGLOBALIZING EMERGING MARKETS Investors have long assumed that emerging market equities offer a premium over developed markets, predicated on higher expectations of real earnings growth. However, over the past decade, this realized premium has been on a steady decline. In 2015, our assumption for emerging market real earnings growth was 4.2%. In the year at hand, the same assumption has dwindled to 3.6%. Nevertheless, investable emerging market economies have managed to avoid any significant banking or currency crisis despite trade conflicts, pandemics and supply chain blockages. Their resilience speaks to the improving flexibility of emerging market economies, and as such, investors should continue to look to emerging markets for their diversified growth opportunities. China’s economic landscape is one of the main reasons for declining growth expectations within emerging markets. In the last five years, China’s influence on global debt growth has been substantial, leading to a balance sheet slowdown, which has dragged on its corporations and households. The International Monetary Fund (IMF) forecasts the country’s debt will increase to 110% of GDP by 2029, and we doubt China can resolve this issue on its current growth trajectory. Policymakers must closely monitor debt risk while incentivizing consumption. We anticipate China will continue to invest in advanced manufacturing and shift more basic industrial production to peripheral emerging market economies to ascend the value chain, although this strategy involves significant short-term costs worsening debt sustainability. Furthermore, increasing protectionism, showcased by the US CHIPS and Science Act of 2022 and the European Chips Act, complicate China’s position in the global semiconductor market. In contrast to China’s challenges, India is a bright spot in the emerging market landscape. Prime Minister Narendra Modi has secured a third term, and we anticipate his continued reinforcement of the core drivers behind his economic strategy. His administration is expected to maintain a strong focus on sound macroeconomic management, boosting investment and infrastructure. Modi’s government has consistently prioritized infrastructure and manufacturing development, which are likely to remain central themes. We expect US-India relationships to remain strong, with both countries focusing on strategic cooperation and economic growth. 02 | THEMES TO WATCH In contrast to China’s challenges, India is a bright spot in the emerging market landscape.
18 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. EXHIBIT DG1 Local Equity Market 5-Year Correlation Matrix and Changes 5-Year Change 5-Year Correlation United States United Kingdom Eurozone Japan China India Taiwan South Korea Brazil Chile Mexico United States -0.07 0.01 0.01 -0.18 0.19 0.00 0.11 0.20 0.06 -0.01 United Kingdom 0.64 0.09 0.08 -0.23 0.07 -0.08 0.08 0.20 -0.07 0.00 Eurozone 0.72 0.87 -0.02 -0.16 0.10 -0.02 0.09 0.17 -0.01 0.02 Japan 0.60 0.64 0.67 -0.23 0.05 -0.01 0.04 0.20 0.00 -0.02 China 0.41 0.35 0.40 0.33 -0.18 -0.23 -0.24 -0.08 -0.17 -0.18 India 0.60 0.55 0.60 0.51 0.36 0.06 0.09 0.25 0.06 0.09 Taiwan 0.57 0.45 0.52 0.52 0.47 0.55 0.03 0.01 -0.07 -0.11 South Korea 0.68 0.64 0.67 0.64 0.44 0.58 0.73 0.20 0.10 0.07 Brazil 0.62 0.62 0.57 0.49 0.34 0.59 0.41 0.57 0.01 0.08 Chile 0.49 0.44 0.46 0.32 0.29 0.40 0.39 0.50 0.51 -0.03 Mexico 0.56 0.59 0.60 0.37 0.31 0.49 0.42 0.59 0.59 0.52 Sources: BNY Advisors, Bloomberg. Data as of June 30, 2024. Allocators can examine shifting correlations to find signs of global reshoring initiatives. Exhibit DG1 demonstrates the shifts in correlations of several local equity markets when excluding the effects of currency. The lower left triangle reflects the most recent observations while the upper right triangle reflects five-year changes. The most notable change is the universal decline of Chinese equities relative to both developed and emerging markets, indicating its declining sensitivity to global economic events (i.e., decoupling). Conversely, countries which are becoming more integrated with global supply chains, such as India, South Korea, and Brazil, show increased correlations. Investors may wish to consider how these trends impact their allocations of developed and emerging market equities within portfolios. 02 | THEMES TO WATCH
19 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 02 | THEMES TO WATCH SHIFTING GEARS IN PRIVATE CREDIT Private investment markets have been effectively allocating startup capital and optimizing the capital structures of young firms for decades. We expect this industry to continue pushing disruptive technology to the forefront of our economy and provide fuel for productivity growth. Looking ahead, we expect sustained expansion in private markets, with a notable emphasis on the private debt sector. Private debt markets, which include direct lending and syndicated loans, have experienced several consecutive years of phenomenally successful fundraising and are transforming a market traditionally dominated by bank lenders. We expect this shift to continue, but cyclical headwinds from a buildup of dry powder and falling interest rates may push private credit yields lower. The main structural force pushing traditional bank lenders out of the industry and toward private lenders is the inherent mismatch between a bank’s sudden liquidity needs and illiquid investments. Private credit funds maintain longer time horizons with minimal cash needs by placing lock-up periods on investor capital; this allows managers to offer more customized loans, which can assist borrowers in preventing default. These features are useful during periods of prolonged economic distress and allow businesses to quickly issue new debt by deferring nearterm interest payments. Additionally, private credit has seen growth in its collateralized loan obligations (CLO) markets, whose complex structure of debt tranches offer a variety of risk and return profiles that investors may not otherwise find in public markets. Recently formed CLO exchange-traded funds (ETFs) have been attracting attention as they make historically inaccessible private opportunities available to the wider investing public. We anticipate the long-term back drop of private credit to remain in place and its continued growth as investors seek opportunities for higher yields and diversification.
20 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 02 | THEMES TO WATCH We acknowledge the long-term momentum of the industry but anticipate two cyclical forces contributing to near term headwinds: (1) the global easing cycle and (2) growing amounts of dry powder. Easing cycles tilt investor allocations toward longer-duration bonds and suppress private credit fundraising as the underlying loans are issued as floating rate debt. This feature was a strong tailwind for fundraising in 2021 and 2022 due to floating rate debt’s resilience to rising rates, but the trajectory of interest rates for 2025 leads us to expect lower yields, and thus lower performance, from private credit investments. According to Exhibit PC1, the Federal Reserve estimates dry powder levels of private credit have risen to $250 billion. The increase in dry powder indicates a growing supply of credit relative to demand, so we expect spreads between public and private market yields to decline as credit managers compete for opportunities to deploy capital. Further, this competition during a period of weaker economic growth and low demand for credit could pressure private credit funds to lower their credit standards to achieve internal rate of return targets, increasing default rates above historical norms. EXHIBIT PC1 Estimated Growth of Dry Powder by Investor Type Sources: Degerli, Ahmet, and Phillip Monin (2024). “Private Credit Growth and Monetary Policy Transmission,” Fed’s Notes. BNY Advisors. Data as of December 31, 2022. Note: Other includes individuals, endowments, funds-of-funds, the manager’s stake, and other types of investors. 0 50 100 150 200 250 '12 '13 '14 '15 '16 '17 '18 '19 '20 '21 '22 $ Billion � Pensions � Sovereign Wealth Funds � Insurance � Private Funds � Other
21 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 02 | THEMES TO WATCH CLIMATE RISK & RESILIENCE With 2024 on track to be the hottest year ever recorded, the urgency of addressing climate change-related risks is becoming increasingly important. Climate change presents two main types of risks: physical and transition. Physical risks, resulting from extreme weather and natural disasters such as thunderstorms, flooding, wildfires, and hurricanes, are contributing to economic losses that are growing faster than our global economy. Transition risks involve challenges associated with the global shift to a low-carbon economy, such as policy and legal risks, market risks, technology, or reputational risks. Global policymakers have made noteworthy progress, but accelerated efforts are essential to achieving the goals set out by the Paris Agreement. Scientists and academics have stated that the decade will be pivotal for our planet, as the actions we take now will determine the sustainability of our future. Organizations can seize this moment by embracing innovative solutions and collaborative efforts that embed climate-risk and resilience considerations into material decision making. Flooding and wildfires are significantly impacting the affordability of home insurance in certain regions, which could have ripple effects on home prices and real estate markets. Some insurers are even withdrawing from high-risk areas altogether. This trend may drive climate migration from high-risk to low-risk zones. The resulting labor shortages could force companies to relocate, potentially devastating local businesses. Cities unprepared for a population exodus may struggle to invest in sustainable climate infrastructure due to reduced tax revenues. Conversely, areas receiving a population influx will need to invest in new infrastructure to support larger communities, potentially exacerbating global climate challenges. “It is imperative that we embrace innovative solutions and collaborative efforts to ensure a resilient and sustainable world for generations to come.”
22 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. PROGRESS REPORT SUMMER 2024 Bipartisan Infrastructure Law & Inflation Reduction Act Funding $82.5B+ funding opportunities announced for clean energy $48.7B+ for 1,000+ selected projects and 4,000+ formula funding awardees $60B+ of private capital in matched federal dollars for selected projects $24.3B+ in closed or conditionally committed loans Source: US Department of Energy. Global policymaking will be a key driver of progress. Policymakers continue to design and implement effective climate policies, from decarbonizing transportation and improving the energy efficiency of buildings, to reducing energy emissions through carbon taxation and formalizing carbon markets.3 Domestically, the Inflation Reduction Act of 2022 has made significant headway with more than $100 billion committed as of July 2024 toward grants, awards and other spending aimed at climate adaptation and mitigation efforts across the US.4 This legislative effort has so far provided stability and support for renewable energy initiatives and new energy technologies, bolstering climate resilience and energy independence nationwide. For corporations, regulatory direction and competitive drivers are compelling many to consider decarbonization pathways as a means of managing climate-related physical and transition risks. Decarbonization initiatives are enabling corporations to increase revenues and lower operating costs while reducing their climate footprint. Climate change is a systemic risk and requires a systemic solution. Addressing this challenge necessitates collaboration across both the public and private sectors, placing a greater responsibility on individuals, businesses, and communities to implement climate adaptation and mitigation strategies to enhance resilience. 02 | THEMES TO WATCH
23 03 EQUITY Our equity return assumptions are developed through forecasts of earnings growth and income accumulation. Earnings growth assumptions start with 10-year projections of inflation and GDP, followed by an evaluation of relative earnings growth and valuations. Our income assumptions are set according to historical levels and consider both dividend and net buyback yields.
24 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. EXHIBIT E1 10-Year Equity Market Expected Returns (Unhedged US dollar, %) Source: BNY Advisors as of November 2024. Exhibit E1 summarizes our current assumptions for several regional equity markets. There are various tactics for estimating equity returns: our methodology is rooted in economic fundamentals using the formula below. The formula aligns our equity expectations with broader economic growth and evaluates whether our long-term compounded return assumptions are reasonable projections. Moreover, the building block framework can be broken down into intuitive parts, enhancing the clarity of our forwardlooking views. Market Capitalization = Nominal GDP × Corporate Earnings Share × Valuations Equity Earnings Market Capitalization Nominal GDP Equity Earnings The three factors from left to right represent nominal GDP, the corporate earnings share5 of GDP, and valuations. We combine these forecasts together to forecast a 10-year compounded return assumption. It is important to note this equation does not include returns attributable to income or net share changes, which must be included separately. 7.4 7.7 7.5 7.8 6.3 5.8 6.8 8.5 -2 0 2 4 6 8 10 Global Emerging Market United States United Kingdom Eurozone Japan Canada Australia Inflation Real Earnings Growth Dividend Yield Net Buyback Yield Currency Total 03 | EQUITY
25 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 03 | EQUITY GDP GROWTH & EARNINGS SHARE The first component in the equation is nominal GDP growth. For the first two years of the forecast, 2025 and 2026, we base our assumptions on our latest Vantage Point report. For periods beyond 2026, our macroeconomic projections represent the mean survey from economic forecasters. We then combine our assumption of nominal growth with the second component of the equation, the corporate earnings share, to develop assumptions of equity earnings growth. It is logical, and consistent with classical economic theory, to assume that corporate earnings relative to nominal GDP will be stable over time, as corporations are unlikely to perpetually grow or shrink relative to their domestic economy. We demonstrate this in Exhibit E2, charting the US corporate earnings share since the 1950s. The evidence suggests that the earnings share tends to fluctuate around some long-term mean; however, it may still contribute or detract meaningfully to equity growth over extended periods of time. For instance, its expansion between 2000 and 2023 contributed approximately 1.7% to annualized equity growth. For the next decade we anticipate US equity market earnings will outpace nominal GDP by 0.5% per year, raising the earnings share from 13.0% to approximately 13.6%. EXHIBIT E2 United States Earnings Share – Corporate Earnings to GDP Sources: BNY Advisors, US Bureau of Economic Analysis, Bloomberg. Data as of June 30, 2024. 6 8 10 12 14 '54 '58 '62 '66 '70 '74 '78 '82 '86 '90 '94 '98 '02 '06 '10 '14 '18 '22 '26 '30 '34 Corporate Earnings Share to GDP (%) Corporate Earnings to GDP Assumption
26 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. In Exhibit E3, we provide a detailed breakdown of our earnings growth projections. As highlighted in the AI theme section, we expect AI to boost equity earnings globally. We anticipate the United States to be best positioned for AI-driven growth due to its investment in AI infrastructure, large share of cognitive labor, favorable regulations, and concentration of firms with dominant positions in the AI ecosystem. We also expect developed markets outside the US to experience enhanced revenue growth, albeit to a lesser extent, as lower infrastructure investment and regulatory hurdles may impede adoption. Conversely, we see slower AI adoption in emerging markets as its higher proportion of the world’s physical labor limits potential productivity growth. EXHIBIT E3 Annualized 10-Year Equity Market Earnings Growth Assumptions Source: BNY Advisors as of November 2024. 2.2 2.5 2.2 2.4 2.0 1.5 2.1 2.3 2.1 3.6 1.8 1.4 1.2 0.7 1.9 2.4 0.4 0.1 0.5 0.4 0.3 0.3 0.3 0.3 Global Emerging Market United States United Kingdom Eurozone Japan Canada Australia Earnings Share Growth GDP Growth Inflation 03 | EQUITY
27 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. VALUATION The third element in our formula is the price-to-earnings ratio. It is important to note that short-term valuation fluctuations only cause temporary changes to asset returns, making long-term valuation forecasts the only relevant factor for our 10-year assumptions. Since forecasts for long-term equity market valuations are the primary source of forecast error, we decided not to make any valuation adjustments this year. Instead, we present Exhibit E4, which details the impact of valuation assumptions on our 10-year US equity return assumption. Our current valuation assumption is that future price to earnings (P/E) ratios will reflect the same values observed on June 30, 2024, depicted by the orange line. If an investor were to apply a long-term valuation multiple of 20 to our forecast, the valuationadjusted US equity assumption would be 6.2%. EXHIBIT E4 Impact of Valuation Assumptions on 2025 US Equity Return Assumption Sources: BNY Advisors, Bloomberg. Data as of June 30, 2024. Chart is for illustrative purposes only. 4 6 8 10 18 19 20 21 22 23 24 25 26 US Equity Return Assumption (%) Valuation Assumption 10-Year Return Impact Forward P/E 03 | EQUITY
28 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. INCOME Income returns are a particularly important, yet often neglected, source of equity returns. The two primary methods of distributing earnings to shareholders are dividends and buybacks (share repurchases). Exhibit E5 shows that these factors have been a meaningful contributor to equity returns in the United States for several decades. Historically, the US has had higher buyback rates compared to the rest of the world mainly because capital gains are taxed at a lower rate than income. EXHIBIT E5 US Equity Income Returns Disaggregated into Dividend Yield and Share Repurchase (%) Sources: BNY Advisors, FactSet. Data as of June 30, 2024. We anticipate dividend and buyback yields will align with historical averages across all regions. Additionally, we expect developed markets to provide investors with higher income returns compared to emerging markets. We believe this characteristic is particularly valuable for risk-averse investors due to the stability of returns generated through income. EXHIBIT E6 Annualized 10-Year Equity Market Income Assumptions Source: BNY Advisors as of November 2024. 0 2 4 6 '04 '06 '08 '10 '12 '14 '16 '18 '20 '22 Net Buyback Yield Dividend Yield 03 | EQUITY 1.9 1.9 1.5 3.6 2.8 2.2 3.1 4.3 0.8 -0.1 1.5 0.2 -0.2 0.4 -0.7 -0.7 Global Emerging Market United States United Kingdom Eurozone Japan Canada Australia Buybacks Dividend Yield
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 29 Our fixed income assumptions rely on a building block approach to project yields over the next 10 years. This approach begins with economic assumptions of inflation and real interest rates, which together form the level of short-rate expectations. We then incorporate expectations of slope to develop sovereign yield curves, creating the foundation of our fixed income assumptions. Next, we forecast credit spreads and default rates for non-Treasury fixed income asset classes. Finally, we conduct a horizon analysis, transitioning yields from their current levels to longterm projections. 04 FIXED INCOME
30 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. EXHIBIT F1 United States Long Term Yield Projections Source: BNY Advisors as of November 2024. Chart is for illustrative purposes only. Exhibit F1 details our normalized projections for the US Treasury curve and several asset classes. We summarize our fixed income expectations within the following sections. Globally, fixed income returns remain high supported by current yields. Within the United States our projection of an easing cycle benefits long-duration Treasuries, although this is modestly offset by a steepening yield curve. Credit sectors benefit less from a steepening yield curve due to shorter duration and projections for widening credit spreads. Outside of the United States, we expect lower returns driven by lower yields and mixed valuation impacts, which for instance benefit UK gilts and weigh on Japanese government bonds. EXHIBIT F2 10-Year Fixed Income Market Expected Returns (Unhedged USD) Source: BNY Advisors as of November 2024. US Aggregate US Investment Grade Credit US Long Investment Grade Credit 1 2 3 4 5 6 Cash 5 10 15 Normalized Yield (%) Duration Inflation Real Cash Rate Slope Spread 3.9 4.8 6.0 4.1 3.5 1.5 4.0 -2 0 2 4 6 8 Global Aggregate US Aggregate US High Yield UK Aggregate Eurozone Aggregate Japan Aggregate Emerging Mkts Sovereign Local Currency Default Valuation Yield 04 | FIXED INCOME
31 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. SOVEREIGN YIELD CURVES Expectations for inflation and short-term interest rates determine the level of our long-term projected sovereign yield curves. Next, we formulate an expectation for the slope of these curves. To do this, we focus our attention on the excess yield of a 10–year Treasury bond over a 3–month Treasury bill (10Y–3M). For other maturities, such as 5Y–3M and 30Y–3M, our long-term projections assume a relationship to the 10Y–3M, best visualized by Exhibit F1. 04 | FIXED INCOME We first perform a regression analysis, which indicates that inflation expectations and short-term real interest rates have significant relationships with the slope of the yield curve. The result of our analysis is shown in Exhibit F3, which compares the simulated results to market observations of the US Treasury curve slope. If we relied purely on this model, our projection of the US Treasury curve’s slope would be approximately 40 basis points (bps). This projection is flat but aligns with historical trends when considering our expectation for a long-term 1.0% real interest rate. EXHIBIT F3 United States Treasury Curve Slope (%) Sources: BNY Advisors, Bloomberg. Data as of June 30, 2024. To refine our projections, we examine historical data and economic forecasts for 10-year and 3-month yields. Our review indicates steeper curves than we estimated, though still flatter than historical levels. A frequent factor pushing up the slope of the yield curve cited by forecasters is the growing level of government debt burdens. This is not captured within our model. Considering all metrics, we anticipate the US Treasury curve’s slope to normalize at 70 basis points. As the economic dislocations brought on by the past several years of global inflation unwind, we expect sovereign bond yields to normalize to longterm levels over the course of five years, more detailed projections are summarized in Exbibit F4. EXHIBIT F4 Normalized Sovereign Yield Curve Projections (%) Maturity US U.K. Eurozone Japan 3 Month 3.2 3.2 2.4 1.0 5 Year 3.7 3.6 2.8 1.3 10 Year 3.9 3.8 3.0 1.4 30 Year 4.1 3.9 3.1 1.5 Source: BNY Advisors as of November 2024. Note: The Eurozone reflects weighted projections of France, Italy and Germany. -2 0 2 4 '04 '06 '08 '10 '12 '14 '16 '18 '20 '22 Simulated 10Y–3M Actual 10Y–3M
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. 32 04 | FIXED INCOME CREDIT SPREADS EXHIBIT F5 US Investment Grade Credit Spread to Treasuries (%) Sources: BNY Advisors, Bloomberg. Data as of June 30, 2024. 0 2 4 6 '04 '06 '08 '10 '12 '14 '16 '18 '20 '22 Historical Spread Winsorized Spread We expect US investment grade credit spreads to widen from 70 bps to 110 bps and US high yield spreads to widen from 310 bps to 470 bps. To develop these assumptions, as well as spread expectations for other asset classes, we assume credit spreads trend toward long-term historical averages. To determine the historical average, we winsorize6 the data to eliminate the impact of extreme events such as the Global Financial Crisis (GFC). This approach can be visualized in Exhibit F5. We anticipate default and recovery rates to be in line with historical averages, according to current quality ratings. For emerging market local and hard currency debt, we apply default and recovery assumptions according to regional market capitalization to capture the elevated credit risk of sovereign borrowers, such as Egypt and Argentina.
33 PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Sources: BNY Advisors, Bloomberg. Data as of June 30, 2024. In exhibit F7, we compare the prevailing yields of various fixed income asset classes with our forward-looking return projections. For asset classes that involve minimal reinvestment, credit or currency risk, our expectations align well with market yields as of June 30th, 2024. A notable exception is inflation-protected securities, where the yield reflects market expectations for real yields and future inflation adjustments. Moreover, the anticipated returns for global aggregate and Treasury bonds slightly exceed current yields when hedged. This reflects our higher expectations of nominal cash rates in the US compared to international economies. COMPARING EXPECTATIONS TO CURRENT YIELDS 04 | FIXED INCOME Investors can mitigate reinvestment risk by extending the duration of their portfolios. Consequently, current fixed income yields have provided a reliable foundation for estimating future performance. We anticipate fixed income returns to be favorable over the next decade, largely because of today’s elevated entry point. To validate our approach, we examine rolling 10-year returns of Bloomberg US Aggregate Index in relation to its starting yield, as shown in Exhibit F6. Applying a regression analysis reveals a coefficient of determination (R-Squared) of 0.91. EXHIBIT F6 Bloomberg US Aggregate Index Returns vs. Starting Yields (%) 0 2 4 6 8 10 12 14 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 '20 '22 10-Year Annualized Return Yield 10 Years Ago
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