Capital Market Assumptions provide 10-year expectations for the most widely held equity, fixed income and non-traditional asset classes, measuring both return and risk. A summary of our key assumptions is provided below.
Q4 2020 Developments Informing Our Long-Term (10-Year) Forecasts: Following a tumultuous first half of 2020 that saw global GDP decline by historic measures through the second quarter attributable to efforts to contain the COVID-19 pandemic, the global economy rebounded sharply in the second half of the year, with US GDP rebounding by better than 33% in the third quarter of 2020 with further modest growth anticipated for the fourth quarter. The sharp rebound in US GDP was coincident with improving measures of employment and consumer spending, though to still below pre-pandemic levels. As of the end of 2020, however, uncertainty surrounding the near-term economic outlook remained elevated, as a second wave in new virus cases in the US and Europe at the onset of winter increased the likelihood that renewed virus containment measures would challenge the nascent global economic recovery. In response to the drop in economic output, global central banks moved aggressively in the first half of 2020 to ease financial conditions, including a return to near zero policy rates in the US and a deeper move into negative rate territory by the European Central Bank. Our near-term global economic growth forecasts have increased modestly from earlier in 2020 with a stronger economic recovery forecast for 2021 as mass vaccinations to control COVID-19 are expected to allow for a greater range of economic activity later in the year. Continued low policy rates and improving forecast economic growth and inflation have important implications for our long-term asset class forecasts. Also contributing to changes in our asset class forecasts are market moves in the fourth quarter of 2020, including a 14% rally in global equities and further spread tightening in speculative fixed income markets during the quarter.
Long-Term Global Economic Outlook: We expect real economic growth in developed economies to continue to moderate over the next decade, as it has for the last 30 years. This is due to limited growth of the developed labor force, which is constrained by domestic demographics, and to an assumption of no significant offset from improved productivity growth. Inflation in developed markets, in contrast, is anticipated to increase modestly over the next 10 years, relative to the low rates of inflation observed since the onset of the Global Financial Crisis of 2008, though that evolution to sustained higher inflation is likely to be slower now as an initial result of the global contraction precipitated by the COVID-19 pandemic. We expect long-run real economic growth and inflation in emerging markets to advance at higher annualized rates. Younger populations and higher rates of return on capital in emerging markets are driving higher rates of nominal economic output compared to developed markets.
Equities: Our 10-year annualized nominal forecast return for global equities is 6.4%, a modest increase from our forecast of 6.3% in the fourth quarter of 2020. The improved forecast reflects an improvement in forward looking corporate earnings offset by the impact of less favorable valuations coinciding with global equities advancing 14% in the fourth quarter as expectations for a strong economic rebound in 2021 took hold in the final quarter of 2020 coincident with the release of a first round of vaccines to control the COVID-19 pandemic. The global equity forecast is also informed by a slower forecast speed of adjustment to long-term valuation ratios introduced earlier in 2020 in response to the uncertain outlook attributable to the pandemic. Our long-term return forecast for US equities is somewhat lower, at 5.8%. Developed market equities outside the US are forecast at 7.4%, with the differential relative to the US largely accounted for by lower historical valuation ratios. Our long-run forecast for emerging market equities is 7.0%, with higher rates of nominal economic growth offset somewhat by comparably lower expected income returns than in developed markets and a negative expected valuation adjustment.
Fixed Income: Global sovereign interest rates finished the fourth quarter of 2020 modestly higher than at the end of the third quarter, following significant declines earlier in the year, coincident with a 1.75% decline in Federal Reserve policy rates and a global economic recession resulting from government containment measures in response to the COVID-19 pandemic. With a very low starting point for initial income returns, our long-run forecast for hedged global aggregate bonds is 0.5%, a decrease from a 0.9% forecast at the end of the third quarter, attributable to a decrease of 13 basis points in the initial spread component of the global aggregate as well as a greater negative expected price adjustment as underlying sovereign rates are forecast to rise over the next 10 years. Our long-run forecast for US aggregate bonds is 1.4%, consistent with higher initial yields in the US. At the end of our 10-year forecast horizon, we expect the US Federal Reserve’s policy rate to be approximately 1.1%, about 100 basis points higher than the midpoint of the near zero policy rate target range at the end of 2020. Outside the US, developed market central banks are forecast to modestly increase policy rates from even lower negative levels in many cases, as some longer-run policy normalization is expected. In US credit markets, we are forecasting a rise in average spread levels over the next 10 years, following a large compression in spreads in the second half of 2020, informing expected returns of 1.6% and 3.1% for US investment grade (IG) and high yield bonds, respectively.
Real Assets: “Real assets” are broadly defined to include asset classes that have physical properties or have returns that are highly correlated with inflation. We include commodities, REITs and TIPS as real assets in our Capital Market Assumptions (CMAs). Our 10-year expectation is that REITs will exceed the forecast rate of US inflation, while TIPS and commodities will underperform that forecast rate of inflation.
Currency and Currency Hedging Returns: Over the next 10 years, we are forecasting a modest decline of the US dollar relative to developed market peers, with annualized gains ranging from 0.0% for the Australian dollar to 1.4% for the Swiss franc. Emerging market currencies, in contrast, are expected to depreciate against the US dollar over the next 10 years. Long-term currency hedging returns against a market weighted basket of developed markets exposures are forecast to be net positive for US investors as short-term interest rates are anticipated to be higher over the long term in the US relative to the Eurozone and Japan.
60/40 Portfolio Return: Based on our long-term forecasts, a balanced portfolio of 60% Global Equities unhedged and 40% Global Aggregate Bonds hedged is forecast to return 4.1% annually over the next 10 years. This forecast is unchanged from the fourth quarter of 2020.