2021 Q2 Capital Market Assumptions
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.
Q1 2021 Developments Informing Our Long-Term (10-Year) Forecasts: With a tumultuous 2020 in the rear-view mirror, the first quarter of 2021 reflected a generally optimistic tone as global economic growth was anticipated to rebound strongly for the year and the COVID-19 vaccine rollout promised something of a return to a broad range of activity before the end of the year that had been sharply curtailed since the end of the first quarter of 2020. The freshly inaugurated Biden administration passed an additional fiscal stimulus package in March, contributing to expectations for US GDP to expand at a better than 6% annualized pace in the first quarter. Europe, in contrast, facing an extended series of additional lockdowns to control lingering pandemic surges, was expected to see a second consecutive quarter of economic contraction in the first quarter before returning to expansion later in 2021. Our near-term US economic growth forecasts have increased modestly from the end of 2020, while our forecasts for emerging market economies have decreased somewhat. 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 first quarter of 2021, including an 83 basis point rise in 10-year US Treasury yields, the largest such move in nearly five years.
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 6.3%, a modest decrease from our forecast of 6.4% in the first quarter of 2021. The near unchanged forecast reflects an improvement in forward looking corporate earnings offset by the impact of less favorable valuations coinciding with global equities advancing an additional 4% in the first quarter. 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 7.1%, with the differential relative to the US largely accounted for by lower historical valuation ratios. Our long-run forecast for emerging market equities is 6.8%, 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, led by the US, finished the first quarter of 2021 significantly higher than at the end of 2020 on encouraging economic news and a continued steady rise in forward inflation expectations. For US fixed income investors in funds that track the Barclays US Aggregate Bond Index, it was the worst quarter from a return standpoint (-3.4%) since the third quarter of 1981. With what is still a very low starting point for initial income returns, our long-run forecast for hedged global aggregate bonds is 1.0%, an increase from a 0.5% forecast at the end of last year, attributable to an increase of 33 basis points in the index yield of the Barclays Global Aggregate as well as yield curve steepening that will benefit roll-down returns. Our long-run forecast for US aggregate bonds is 2.4%, 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 0.9%, about 80 basis points higher than the midpoint of the near zero policy rate target range at the end of the first quarter. 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 over the past year to pre-pandemic levels, informing expected returns of 2.9% and 3.5% 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).
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 0.1% for the Australian dollar to 1.5% 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 Return1: Based on our long-term forecasts, a balanced portfolio of 60% Global Equities unhedged and 40% Global Aggregate Bonds hedged is forecast to return 4.6% annually over the next 10 years. This forecast represents an increase of 0.5% from the end of the first quarter attributable to a broad increase in our global bond forecasts as well an increased diversification gain in the calculation of our forecast from last quarter.
1 For illustrative purposes only. All model portfolios have significant inherent shortcomings and do not consider many real-world frictions. There is no current PGIM Quantitative Solutions client portfolio with this composition of assets. It does not constitute investment advice and should not be used as the basis for any investment decision.