2021 Q4 Capital Market Assumptions
Summary
Q3 2021 Developments Informing Our Long-Term (10-Year) Forecasts: A robust global recovery from the pandemic-induced downturn continued in the third quarter despite speed bumps from the COVID-19 Delta variant spreading around the world. The U.S. economy grew 6.6% in the second quarter, and reached a key milestone as it recouped all lost output from the recession. However, U.S. economic releases this quarter signaled something of a pause in the recent run of strong growth. Retail sales declined in July, the first dent in strong consumer spending that has persisted over the past year, and a disappointing jobs report in August highlighted the challenges of a reintegrating its labor supply. Inflation measures, however, continued to tell a strong growth story, with U.S. headline inflation increasing 5% year-over-year for a third consecutive month this quarter. Our near-term developed and emerging market economic growth and inflation forecasts have increased modestly from the previous quarter. Continued low policy rates and improving forecast economic growth and inflation have important implications for our long-term asset class forecasts.
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 our baseline long-term inflation expectation has increased only modestly from last quarter, 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 U.S. inflation has at least temporarily paused, and inflation may remain higher 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 6.6%, a meaningful increase from our forecast of 5.8% in the third quarter of 2021. The forecast increase is primarily driven by higher expected rates of developed market growth and inflation over the next two years as the global economy recovers lost output from 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 COVID-19 pandemic. Our long-term return forecast for U.S. equities is somewhat lower, at 6.1%. Developed market equities outside the U.S. are forecast at 7.3%, with the differential relative to the U.S. largely accounted for by lower historical valuation ratios. Our long-run forecast for emerging market equities is 7.7%, 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.
10-Year Forecast Returns and Volatility
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Fixed Income: Global sovereign interest rates, were mostly unchanged in the third quarter of 2021 following a significant rise in yields year to date 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 1.2%, up slightly from our forecast in the third quarter. Our long-run forecast for U.S. aggregate bonds is 2.2%, consistent with higher initial yields in the U.S. At the end of our 10-year forecast horizon, we expect the U.S. 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 third quarter. Outside the U.S., 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 U.S. 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 2.6% and 3.2% for U.S. 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).
Private Assets: Given the increasingly important role private asset classes play in a growing number of institutional allocations, beginning this quarter, PGIM Quantitative Solutions is now producing forecasts for U.S. buyout private equity, U.S. venture capital private equity and U.S. mezzanine private debt. Our methodology for forecasting private assets ties the forecast outcomes of private assets to those of public market assets and assigns a premium consistent with historical empirical outcomes, acknowledging the underlying illiquidity and potential leverage employed in these asset classes relative to public market counterparts.
Currency and Currency Hedging Returns: Over the next 10 years, we are forecasting a modest decline of the U.S. dollar relative to developed market peers, with annualized gains ranging from 0.3% for the Australian dollar to 1.8% for the Japanese yen. Emerging market currencies, in contrast, are expected to depreciate against the U.S. 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 U.S. investors as short-term interest rates are anticipated to be higher over the long term in the U.S. 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 4.8% annually over the next 10 years. This forecast represents an increase of 0.5% from the third quarter attributable to increases 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