Schwab's 2024 Long-Term Capital Market Expectations (2024)

Toachieve your long-term financial goals,it's crucial to maintain realistic expectationsabout the market. Being overly optimisticmight lead to insufficient savings, assuming investments will growrapidly enough to fundfuture plans likeretirement or achild's education.Conversely, excessively pessimistic expectationscould result in over-saving, sacrificingcurrent spending and enjoyment.

To guideinvestors, we diligently updateour long-term Capital Market Expectations (CMEs)every year. This helps ensure we adapt to the ever-changing market environment and provideyou with the mostrelevant projections. Schwab's long-term CMEs are quantitative forecastsdesigned to offer reasonable expectations for risks and returns over the next 10years. Theseestimates are nominal, meaning they include inflation; annualized, meaning they are a yearly average rate of return; and calculated over a 10-year horizon,meaning they provideforecasts10 years into the future. CMEs are created for representative benchmark indices rather than specific investment vehicles (like exchange-traded funds or mutual funds). As such, they do not account for the impact of fees or taxes. These forecasts play an essential role in a variety of decisions, such as determining optimal portfolio allocations andbuilding realistic retirement plans.

Compared to lastyear,our outlook highlights better opportunities for cash andbonds, primarilydrivenby higher starting yields.Although support forstock valuationshas diminished given the higher prices, the change in expected returns is tempered by an improvedearnings growth outlook. The net resultis a similar return outlook for stocks.

Given recent market changes, now may bean opportune timeto reassess your long-term financial goals, confirming they are based on projections grounded ina disciplined methodology.

While many investors were hoping for a return to normalcy after the economic, financial, and geopolitical disruptions in recent years, several macroeconomic uncertainties have yet to resolve themselves. A few key investment risks—namely, inflation, recession, and geopolitical—remain top of mind for investors. Amid these uncertainties, the S&P 500^® is still up year-to-date, and the Federal Reserve (Fed) has continued to raise short-term interest rates, albeit in small increments compared to 2022. Furthermore, the Fed's commitment to "higher-for-longer" policy means that valuations across asset classes may need to contend with higher short-term rates over the coming years. In light of these ongoing uncertainties and market shifts, we have made some adjustments to our forecasts for 2024.

Using data as of 10/31/2023, our latest estimates cover the period from 2024 to 2033.

Macroeconomy:While inflation has moderated from recent highs, its persistence in remaining above central bank targets remains a risk for investors. In contrast, U.S. gross domestic product (GDP) growth has shown remarkable resilience, surpassing economist expectations. The divergence between robust economic growth and lingering inflation has posed a formidable challenge for central banks.

When constructing our forecasts for inflation and real GDP growth over the next decade, we use a survey-based approach that considersthe entire 10-yeartrajectory. Thismethod accounts for near-termfactors, such as heightened inflation and dampened GDP prospects, in our long-term estimate.While we are still confident in our approach, we do acknowledge increased uncertainty surrounding these estimates in thecoming decade.

We expect inflation to remain elevated in the near-term as it gradually moderates toward the Fed's neutral rate. This outlook reflects our belief that central banks will succeed in reining in inflation. Nevertheless, we expect the average level of inflation to remain higher than the pre-pandemic era. This year, we are adjusting our 10-year inflation forecast for the U.S. from 2.5% to 2.3%. It is important to note that this adjustment doesn't signify a shift in our longer-term trend; rather, it's a recognition of a lower initial starting point. In other words, while inflation for 2023 still exceeds the target rate, this starting point is notably lower than the 6.5% experienced in 2022.

Due to interventions by the Fed aimed at curbing inflation, we expect a near-term economic slowdown as the impact of rate hikes catches up with robust demand. Despite these short-term disruptions, our expectation is for U.S. GDP growth to stabilize over time. As such, we have adjusted our real GDP expectations for the U.S. from 1.8% to 1.7%, suggesting a less robust expansion compared to the prior decade.

Historical inflation data from U.S. Bureau of Labor Statistics. Historical realgross domestic product (GDP) data from U.S. Bureau of Economic Analysis. Forecast data from Consensus Economics. All data as of 10/31/2023.

Numbers rounded to the nearest one-tenth of a percentage point. Annualized historical inflation based on monthly Consumer Price Index for All Urban Consumers. Annualized historical real GDP growth based on annual realGDP (Not Seasonally Adjusted). RealGDP (Not Seasonally Adjusted)as of 12/31/2023 estimated usingforecast datafrom Consensus Economics. Past performance is no guarantee of future results.

Bonds and cash equivalents: After a year of continued rate hikes in response to unexpectedly persistent inflation, the U.S. Treasury curve remains inverted (where shorter-term bonds have higher yields than their longer-term counterparts) and bond yields have reached their highest levels in over a decade.

Since the yield-to-maturity of a bond is closely tied to the annual rate of return an investor can expect if held to maturity (assuming all interest payments are reinvested at the same rate), these higher yields have resulted in a more favorable outlook for bonds, offering the most compelling expected returns in years. For instance, U.S. investment-grade bonds are expected to yield an annual return of 5.7% over the next decade, up from our 4.9% forecast last year. We expect bond returns to closely align with yield-to-maturity given the flatter-than-average curve.

Typically, investors seek a higher return when they invest in longer-term bonds as compensation for committing their funds and navigating through additional uncertainties, such as changing inflation and interest rates. This added compensation is commonly referred to as the "term" premium, and it can fluctuate based on various market factors. Recent developments, such as the Fed's commitment to a "higher-for-longer" stance, have introduced some upward pressure further along the yield curve. As such, we have seen the expected term premium continue to rise. This trend has resulted in an even greater improvement for our longer-term bond outlook when compared to last year.

Similar to bonds, cash-equivalent investments like Treasury bills have also benefited from these higher starting yields. Our cash forecasts are based on the expected evolution of the yield curve as rates adjust to a more normalized environment, falling between today's restrictive policy levels and the low interest rate regime of the past decade. Consequently, our cash rate forecast over the next 10 years has risen from 3.3% to 3.6%.

We continue to expect that cash and bond returns will outpace inflation, suggesting positive real returns (i.e., returns after accounting for inflation). This potential for a more attractive source of income marks a welcome shift from the trends of the last decade.

Stocks:Throughout 2023, the financial landscape experienced notable fluctuations driven by major market events, such as the regional banking crisis. Despite these difficulties, the S&P 500^® is still up year-to-date. Typically, an increase in prices would mean lower expected returns due to a higher and less attractive starting valuation. However, the dynamics in the market go beyond just market prices. Stock valuations are also influenced byexpected cash flows (e.g., dividends).Despite our long-term growth outlook staying subdued, there has been a positive shift in expected earnings growth compared to 2022. These factors feed into our valuation-based model, suggesting that any potential decline due to elevated stock prices has been counteracted by the improved earnings growth outlook.

The equity risk premium (ERP) is the additional return stocks provide over a "risk-free" investment, such as a Treasury security, as compensation for the heightened risk of stock investing. It acts as a yardstick for evaluating whether stocks are expensive or cheap compared to safer investments.This year, the expected ERP is less enticing compared to earlier decades, primarily attributable to higher bond yields. This means that while stocks are expected to have higher returns than bonds, the margin has narrowed. Additionally, when assessed on a risk-adjusted basis, bonds present an appealing option when compared to the more volatile nature of stocks.

To capture the broad movements of the market, werely on robust predictors such asstock valuations and bond yields when constructing the core return drivers of our framework.As a result, changes in market price, policy rates, and inflation have important implications for our outlooks. Whenever possible, we adopt a forward-looking approachwhen forecasting returns rather thanbase our estimates solely on historical averages. We believe this method provides a more robust view of future returns. Prior to publication, the various components and final forecasts undergo thorough review by senior investment professionals.

For inflationandGDP growth, we use a survey-based approach based on economist expectations. We find this approach beneficial forseveral reasons: (1) professional forecasters incorporate new and relevant information into their updated expectations; (2) these expectationstypically align with prevailing viewson economic policy; and (3)this approach provides a relatively stable forecast, a desirable feature for retirement planning and asset allocation models.

ForbothU.S. and international large-company stocks,our starting point is the belief that stock marketsfunction as a discounting mechanism. This means that the currentstockpriceis an attempt tofactor in all available information about present and future events.To achieve this, we use a valuation-based model that discounts the future cash flows an investor is expected to receive, such as dividends, to the current price of a stock.

The effectiveness of this approachrelies on the inputs used. We use forward-looking earnings estimates and macroeconomic forecast data to estimate two key cash-flow drivers: (1) recurring income, such as dividends, and (2) capital gainsresulting from selling the investment at the end of a predetermined horizon, such as 10years. To arrive at a return estimate, we answer the question: "What returns would investors make if they bought a stock at the current price and received theseprojected cash flows?"

For U.S. small-company stocks, webuild upon the valuation-based model used for large-company stocks as ourbaseline. We then analyze andincorporate a "size"risk premium, which is the return that investors in small-company stocks expect to earn over the returns on large-company stocks.

For U.S. investment-grade bonds (i.e., Treasuries, investment-grade corporate bonds, and securitized bonds), we believethat futurereturns are closely tied to yields. For example, if an investor buys a 10-year Treasury note with a4% yield-to-maturity andholds the investment until maturity, then the investorcan expect to realize a4% return per year (assuming all interest payments are reinvested at the same rate). We consider the following components when forecastingbond returns:

• Yield-to-maturity of a "risk-free" bond. Treasury notes are fixed-income securities issued by the U.S. governmentknown for generating what is considered a "risk-free" rate,primarily due tothe negligible chance ofdefault (though they still carry duration risk). Since the U.S. Treasury does not provide yields for every maturity, we use a yieldcurvefitting model toaddress this gap. This fittedTreasury curve provides duration-matched yields for any fixed income asset class that we need to model.
• Yield spread.Additionalyieldoffered above therisk-free rate, compensating investors forcredit and/or default risk. Thisrisk reflects the possibility thatthe bond's issuer will be unable to pay its obligations on time, or at all. The credit risk premium increases with a lower credit rating,reflecting the heightened risk associated with owning theissuer's debt. In a perfect world,investors would receive the entire stated yield over the life ofa bond, but due topotential default loss and downgrades, some bonds may only earn around 50% of the observed yield spread.
• Roll-down return.Since investors typicallyparticipate inthebondmarkets via indices designed to maintain an average duration, wefactor in this additional return. Toadhere to a target duration,these indices periodically rebalancetheir portfolios by selling bondsnearing maturityand buying longer-maturity bonds. Given the inverse relationship between bond yields and prices, this processoften results ingains for an upward-sloping yield curve (where longer-term bonds have higher yields than shorter-term bonds).The opposite holds truefor an inverted yield curve.

Forcash investments,as they areinherently short-term in nature (typicallyno longer than three months), we assume reinvestment at the end of each period over a 10-year horizon. To forecast this rate, we use amodel that factors in thetermstructureand the expected evolution of the yield curve over the next decade.

When planning for the future, relying solely on historical returns can lead to unrealistic expectations.The consequences of actual returnsfalling short of expectations can be significant,such as a delayed retirement or difficulty paying formajor expenses such as a college education.Schwab takes a more comprehensive approach, incorporating forward-looking information like consensus-driven earnings and macroeconomic forecast data to create a more robustview of future returns. Over the next decade, Schwab expects market returns to fall short of long-term historical averages due toshifts in interest rates, growth prospects, andstock valuations.

• Interest rates.While current and expected interest rates are notably higher than the past decade, they are still much lower than the high-interest-rate environment of the1980s. Althoughthe future path of interest rates is uncertain, we expect the average level of rates to be higher in the coming years than in the previous decade. Whileour estimates account for this higher-rate environment,we still do not believe interest rates will reach historical highs.
• Economic growth. Stubbornly high inflation hasprompted central banks tocontinue tightening monetary policy,albeit in smaller increments compared to 2022. While economic growth has shown resilience to these interventions, we expect anear-term economicslowdown as the impact of rate hikes catches up with robust demand. Additionally,long-termconsensus forecastsare still subdued compared to earlier decades. This affects our return outlook, as a robust economy is fundamental to achieving healthy returnsin financial markets. According to consensus forecasts, economists expectaveragereal GDP growthin the U.S.to be 1.7% over the next 10 years,notably lower thanthe historical average of 2.7% per year since 1970.
• Stock valuations.Despite an improved earnings growth outlook in the U.S., any potential attractivenessappears to betempered byelevated stock prices. At their current levels, we would need to see strongerearnings growthto justify a higher return expectation. On the international front, although valuations appear more appealing, we continue to expect stock returns tofall below historical levels.

U.S. large-company stocksare expectedto return 6.2% annually over the next 10 years,trailing the expected 7.6% return for international large-company stocks.The driving force behind this modestly higher outlook for international stocks is their more attractive valuations compared to their U.S. counterparts.

While we expect stronger earnings growth from domestic stocks, international stocks present a compelling case with their lower valuations andhigher dividend yield. It's worth noting thatinternational stocks generallycome with higher risk, and investors expect to be compensated for taking on this additional risk.Despitehistorical returnsfavoring domestic stocks, thecurrent price given theexpected cash flows suggestthat international stocks have a betterstarting valuation and may outperform over the long-term.

Due to the power of compound returns—the cumulative effect that gains or losses have on an original investment—evenminor differences can result insubstantial changes over time. Therefore, what investors do (ordon't do) today can have a sizeable impact on the likelihood ofreaching their long-term investment goals. By incorporating realistic return assumptions into the financial-planning process, investors are better able to plan for theirfuture.

If youdon't have a long-term financial plan, nowmay be an opportune time to start putting one together. If you already have one, then consider revising it based on Schwab's updatedoutlook. Bear in mind thatpredicting the future of any individual investment with absolute certainty is impossible. Therefore, CMEs arenotintended for market timing; instead,they shouldserve as a guide to set reasonable long-term expectations for financial goals and asset allocation plans.

Here aresome considerations moving forward:

• Establishrealistic financial goals. Createa financial plan based on your goals and beadaptable as your life circ*mstances change. Use our updatedreturn outlookto help you be more realistic when creating your financial plan.
• Saving discipline. While expected returns have seen fluctuations this year, resist the urge toreduceyour savings. Expected returnscan varyyear-to-year and are far from a guarantee. The more you save, the more cushion you have in case actual returnsdeviate from expectations.
• Diversification matters.Build a diversified portfolio based your risk tolerance. Various asset classes, like stocks, bonds, or cash,behave differently in changing marketconditions. Predicting the best-performing assetclass in a given year is challenging, so opt for diversification to mitigate the impact of market volatility rather thanchasing past performance.