Economic growth in the United States and overseas will remain tepid for several years before returning to historical norms, with fixed income returns staying low to the point of offering little or no return above inflation. Equities are not expected to be hurt as much as fixed income as more meaningful growth eventually resumes. These are two of the primary conclusions of Wilmington Trust’s 2011-2017 Capital Markets Forecast, the new installment of the company’s annual long-term outlook for the financial markets.

“The global economy is continuing to recover slowly from a severe financial crisis,” said Rex Macey, CFA®, CFP®, CIMA®, senior vice president and chief investment officer for Wilmington Trust’s Wealth Advisory Services (WAS) business. “As a result, we see lingering weak economic growth and low inflation for several years to come. Toward the end of our forecast period, we expect growth to accelerate, which should be accompanied by an increase in interest rates and inflation.”

The forecast, which is produced by Wilmington Trust’s Investment Strategy Team, underscores the importance of diversification among a variety of asset classes, including global equities, real assets (commodities, inflation-linked bonds, and real estate), and hedged strategies. This year’s edition calls for inflation to rise averaging about 1.5% annually, or roughly half of its historical level, given the current low inflation environment, excess capacity, and high unemployment. It also introduces an allocation to quality, income-oriented equities for some investors and sees continued relatively brighter expectations for non-U.S.-based equities.

Income-oriented and international equities favored

Quality income equities will produce more income over our forecast horizon than bonds, but investors will have to tolerate the additional price volatility associated with stocks, Mr. Macey said. “We describe income as ‘quality’ if investors can be reasonably confident that the income stream, generally in the form of dividends, can continue for an extended period.”

In addition, Wilmington Trust’s expectations for international equities, both in developed and emerging markets, are higher than those for U.S. equities, though they are still modest compared with historical returns over the long term. As a result, the company is recommending a greater commitment to international equities in many client portfolios. “Broad indices of developed and emerging international equity markets have been fairly consistently outperforming broad indices of the U.S. equity market for many years,” Mr. Macey added. “We project that international equities will continue to outperform over the next seven years, albeit with greater volatility than the U.S. market.”

Struggles ahead for fixed income

Fixed income securities will likely have to endure a period of diminished returns, especially for cash equivalents and inflation-linked bonds, which are going to struggle to produce any positive real yields, Mr. Macey said. The outlook for investment-grade, nominal bonds – those whose prices are not indexed to the rate of inflation – is also subdued. “There may be a relatively small silver lining for municipal bonds, whose taxable-equivalent returns should exceed those of taxable bonds, especially in light of the great likelihood of increasing marginal tax rates. But both categories are apt to disappoint large numbers of investors who use historical returns as a benchmark for likely future returns.”