2021 Q3 Capital Market Assumptions
Summary
Q2 2021 Developments Informing Our Long-Term (10-Year) Forecasts: The Global economy continued to expand strongly in the second quarter of 2021. Growth in developed markets this year has been led by the US, with US GDP increasing over 6% at an annualized rate for the final 2021 Q1 estimate, with even faster growth anticipated for the second quarter. Strong economic and jobs growth also coincided with increasing inflation concerns. Headline US consumer prices rose at their fastest pace since the Global Financial Crisis, hitting a 5.0% annual rate in May. Much of this strength was related to a low base of comparison in 2020, but month-over-month statistics and other adjusted figures also showed upward pressure on prices. Further concerns emerged in the second quarter as well regarding the impact of the COVID-19 Delta variant and its heightened contagiousness, as well as what other variants might arise in the face of slowing rates of vaccination in the US and lack of vaccine availability in many emerging markets. Our near-term developed market 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 broad declines in global sovereign interest rates and a 5.6% rise in global equity markets.
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, with a marked increase in 2021 expected to moderate beginning in 2022. 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. While we have not yet changed our baseline long-term inflation expectation, we are less sanguine about inflation than what we are currently hearing from the central banks. We believe an inflation regime change could be underway once the deflationary shock of the pandemic fades into memory. The four-decade trend in falling US inflation has likely ended, and inflation will probably increase at a higher rate over the next decade. While an extreme scenario of 1970s-style, double-digit inflation appears unlikely, the potential for a sustained period of 3-4% average inflation is a non-trivial risk for investors. We cover these issues at length in a related white paper.
Equities: Our 10-year annualized nominal forecast return for global equities is 5.8%, a decrease from our forecast of 6.3% for the end of the second quarter of 2021. The forecast reduction reflects the impact of less favorable valuations coinciding with global equities advancing an additional 5.6% 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 COVID-19 pandemic. Our long-term return forecast for US equities is somewhat lower, at 5.2%. Developed market equities outside the US are forecast at 6.7%, with the differential relative to the US largely accounted for by lower historical valuation ratios. Our long-run forecast for emerging market equities is 6.7%, 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, declined broadly in the second quarter of 2021 following a much larger magnitude rise in yields in the first quarter consistent with a broad reflation theme in global markets as both growth and inflation expectations shifted higher to start 2021. 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%, unchanged from our forecast at the end of the first quarter. Our long-run forecast for US aggregate bonds is 2.2%, 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 0.7%, about 60 basis points higher than the midpoint of the near zero policy rate target range at the end of the second 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 below pre-pandemic levels, informing expected returns of 2.5% and 2.9% 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 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 4.3% annually over the next 10 years. This forecast represents a decrease of 0.3% from the end of the first quarter attributable to declines in both our global bond and equity forecasts.
^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.