Introducing 2022 Q2 Capital Market Assumptions
Lorne Johnson discusses how income, growth and valuation inform our Capital Market Assumptions.
Q1 2022 Developments Informing Our Long-Term (10-Year) Forecasts: The most recent estimates of US GDP showed annualized growth jumped to 6.9% in the final quarter of 2021 on the back of a strong buildup in business inventories. GDP growth was also helped by consumption, which grew at a solid pace, but at a fraction of the strong growth seen earlier in the year. Concerns about multi-decade- high levels of inflation in developed economies continued to grow. Already in a strong uptrend, commodity prices experienced sharp spikes as Russia’s invasion of Ukraine led to supply shocks, further intensifying inflationary pressures. Headline and core US inflation readings, which exclude more volatile elements such as energy, advanced to new multi-decade highs. This prompted global central banks to accelerate plans for tightening monetary policies. Both short- and long-term rates rose quickly in anticipation of faster hiking cycles, while inflation expectations moved only moderately higher for longer-term outlooks. The speed of short-term rate increases caused a temporary inversion in the 10Y – 2Y Treasury yield spread, often a harbinger of slower economic growth. Global equity markets declined in the first quarter, with US equities falling over 12% for the quarter through early March before recovering somewhat to close the quarter down 5.2%. As a result of the supply shock coincident with Russia’s invasion of Ukraine, the Bloomberg Commodity Index advanced by 25.5% in the first quarter, the strongest such quarterly reading since the third quarter of 1990, amid the Iraqi invasion of Kuwait. Our near-term developed and emerging market economic growth and inflation forecasts are similar to those 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 the limited growth of the developed labor force, which is constrained by domestic demographics. An assumption of no significant offset from improved productivity growth is an additional constraint on 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 and early 2022. Nevertheless, inflation 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 US inflation has at least temporarily paused with US 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 of average inflation well above central bank targets is a non-trivial risk for investors. We cover these issues at length in two related white papers - Is Inflation About to Revive? and Portfolio Implications of a Higher US Inflation Regime.
Equities: Our 10-year annualized nominal forecast return for global equities is 6.0%, a modest increase from our forecast of 5.7% in the first quarter of 2022. The forecast increase is primarily attributable to somewhat more favorable valuations following a decline in global equities of 5.3% in the first quarter. Our long-term return forecast for US equities is somewhat lower, at 5.3%. Returns for developed market equities outside the US are forecast at 7.0%, with the differential relative to the US largely accounted for by lower historical valuation ratios. Our long-run forecast for emerging market equities is 7.9%, 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 markedly in the first quarter of 2022 as inflationary pressures prompted a ratcheting up in expectations for global central bank interest rate hikes. Our long-run forecast for hedged global aggregate bonds is 2.6%, a doubling in our forecast of 1.3% from the first quarter of this year. Our long-run forecast for US aggregate bonds is 3.7%, consistent with higher initial yields in the US. At the end of our 10-year forecast horizon, we expect the US Federal Reserve’s (Fed) policy rate to be approximately 1.4%, about 100 basis points higher than the midpoint of the policy rate target range at the end of the first quarter. Outside the US, developed market central banks are forecast to also increase policy rates from even lower negative levels in many cases, as longer-run policy normalization is expected. In US credit markets, we are forecasting average spread levels to keep broadly in line with current spread levels over the next 10 years, following a modest rise in the first quarter, informing expected returns of 4.2% and 5.0% 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 forecasts for all these asset classes are forecast to outperform our 10-year US inflation forecast of 2.3%.
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 US buyout private equity, US venture capital private equity and US 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 in the first quarter of 2022, we as well introduced forecasts for core and opportunistic US 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 mixed returns for the US dollar relative to developed market peers, with outcomes ranging from annualized loss of 0.3% for the British pound to a gain of 1.3% for the Japanese yen. Forecast outcomes for emerging market currencies range from an expected loss of 2.3% for the South African rand to a gain of 0.7% for the Taiwan dollar. Long-term currency hedging returns against a market weighted basket of developed market exposures are forecast to be net positives 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 5.1% annually over the next 10 years. This forecast represents an increase of 0.7% from the first quarter, attributable primarily to the rise in global interest rates to date in 2022.
* 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.