Q4 2021 Developments Informing Our Long-Term (10-Year) Forecasts: U.S. economic growth accelerated in the fourth quarter at an estimated annualized rate of 6.9%, taking growth for the full year to 5.5%, the strongest reading since 1984. That strong rate of economic growth following the pandemic induced recession of 2020 is expected to moderate in 2022 both in the U.S. and globally as the impact of emergency fiscal and monetary policy support is expected to wane. Further hastening a move to expected tighter monetary policy is rising global inflation which in the U.S. reached 7% at the end of 2021. Global equity markets continued to advance in the fourth quarter, despite some hesitation in November on the discovery of the Omicron COVID-19 variant, with the MSCI World Index advancing 7.8% and 21.8% for the fourth quarter and 2021, respectively. The strong economic backdrop also supported commodities in 2021 with the Bloomberg Commodity Index advancing 27.1% for the year, the strongest gain since 2000. Global interest rates rose modestly in the fourth quarter following a significant rise higher earlier in 2021. The U.S. 10-year Treasury yield finished 2021 at 1.51%, a rise of 0.6% from the end of 2020. Our near-term developed and emerging market economic growth and inflation forecasts have decreased modestly from the previous quarter. Evolving policy rates and a moderation in 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 moderate over the next 10 years, relative to the elevated rates of inflation observed in 2021, though is expected to be somewhat higher than that observed in the period following the Global Financial Crisis of 2008, and prior to the COVID-19 induced recession of 2020. 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 expectations assume a reversion to longer term trends, the nearer term outlook for inflation is highly uncertain. The four-decade trend in falling U.S. inflation has at least temporarily paused with U.S. inflation rising to 7.0% in 2021, and potentially remaining elevated over the next several quarters. While an extreme scenario of 1970s-style, double-digit inflation appears unlikely, the potential for a sustained period average inflation well above central bank targets 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 5.7%, a meaningful decrease from our forecast of 6.6% in the fourth quarter of 2021. The forecast decrease is attributable to moderating expected rates of developed market growth and inflation over the next several quarters from the high levels observed in 2021. The decrease in the global equity forecast is also attributable to less favorable valuations following the 7.8% advance in Global equity markets in the fourth quarter. Our long-term return forecast for U.S. equities is somewhat lower, at 5.1%. Developed market equities outside the U.S. are forecast at 6.6%, 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 7.6%, 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 rose modestly in the fourth quarter of 2021 following a more significant rise in yields early in 2021 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 1.3%, up slightly from our forecast in the fourth quarter. Our long-run forecast for U.S. aggregate bonds is 2.5%, 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 0.8%, about 70 basis points higher than the midpoint of the near zero policy rate target range at the end of the fourth 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 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 2.7% and 3.4% 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 in the fourth quarter of 2021, PGIM Quantitative Solutions introduced forecasts for U.S. buyout private equity, U.S. venture capital private equity and U.S. mezzanine private debt. Our methodology for forecasting these 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. Beginning this quarter, we are also including forecasts for core and opportunistic U.S. Private Real Estate based on inputs from the NCREIF property indices and linkages to forecast economic growth and inflation.
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 0.0% for the Australian dollar to 1.5% 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 4.4% annually over the next 10 years. This forecast represents a decrease of 0.4% from the fourth quarter attributable to decreases in our global 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.