2022 Q3 Capital Market Assumptions
Summary
Q2 2022 Developments Informing Our Long-Term (10-Year) Forecasts: US GDP was estimated to have declined for two consecutive quarters through the first half of 2022 amid a reduction in inventories, strong import growth, and flagging investment spending in the second quarter. Nevertheless, several key components including consumer spending remained upbeat, highlighting the strength of domestic demand. Other US economic data, however, were mixed, as forward-looking business surveys trended steadily downward and higher yields impacted rate-sensitive areas of the economy such as housing. While the all-important jobs sector remained resilient, investors kept their focus primarily on rising inflation data. Sharply higher consumer prices coupled with rising inflation expectations led the US Federal Reserve (Fed) to hike interest rates by 75 basis points in June, the largest increase in nearly 30 years. Central banks globally reassessed their monetary policies and turned more hawkish in the face of higher inflation. Continuing knock-on effects from Russia’s invasion of Ukraine and concerns about supply chain disruptions due to China’s renewed COVID lockdowns worked to raise the specter of a possible recession in the coming year. This caused global central banks to adopt an increasingly hawkish stance and take a more ominous tone. For the US, consensus mean forecasts for 2022 and 2023 call for 2.6% and 1.8% real GDP growth and 7.7% and 3.6% CPI inflation, respectively. The Bloomberg Commodity Total Return Index declined by 5.7% in the second quarter of 2022, reducing total year-to-date gains to a still impressive 18.4%. 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 the first half of 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-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 9.1% through the first half of 2022. 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 papers1.
Equities: Our 10-year annualized nominal forecast return for Global Equities is 7.7%, a material increase from our forecast of 6.0% for the second quarter of 2022. The forecast increase is primarily attributable to more favorable valuations following a 15.5% decline in Global Equities in the second quarter. Our long-term return forecast for US Equities is somewhat lower, at 7.1%. Returns for Developed Market Equities outside the US are forecast at 8.8%, with the differential relative to the US largely accounted for by lower historical valuation ratios. Our long-run forecast for Emerging Market Equities is also 8.8%, with higher rates of nominal economic growth somewhat offset by comparably lower expected income returns than in developed markets and a negative expected valuation adjustment.
Fixed Income: Global sovereign interest rates continued to rise markedly in the second 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 3.9%, an upward revision from the second quarter’s forecast of 2.7%, and up from just 1.3% from the first quarter of this year. Our long-run forecast for US Aggregate Bonds is 4.1%, consistent with higher initial yields in the US. At the end of our 10-year forecast horizon, we expect the US Fed’s policy rate to be approximately 2.4%, which is about 80 basis points higher than the midpoint of the policy rate target range at the end of the second quarter. Outside the US, developed market central banks are forecast to also increase policy rates from lower levels in many cases, as longer-run policy normalization is expected. In US credit markets, we are forecasting average spreads will decline somewhat from the elevated levels witnessed at the end of the second quarter over the next 10 years, following a meaningful rise in the first half of 2022, informing expected returns of 4.9% and 7.5% 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). Our forecasts for all these asset classes are expected to outperform our 10-year US inflation forecast of 2.5%.
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 an annualized loss of 0.5% for the Australian dollar to a gain of 1.2% for the Japanese yen. Forecast outcomes for emerging market currencies range from an expected loss of 2.7% for the South African rand to a gain of 0.6% 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 Return2: Based on our long-term forecasts, a balanced portfolio of 60% Global Equities unhedged and 40% Global Aggregate Bonds hedged is forecast to return 6.6% annually over the next 10 years. This forecast represents a material increase of 1.5% from the second quarter, attributable to both the rise in global interest rates to date in 2022 as well as improved equity market valuations.
1 Tokat-Acikel, Ahmed, Brundage, Campbell, Cummings, & Rengarajan, 2021, “Is Inflation About to Revive?” PGIM Quantitative Solutions White Paper. https://www.pgimquantitativesolutions.com/research/inflation-about-to-revive
Johnson, Aiolfi, Hall, Patterson, Rengarajan, &Tokat-Acikel, 2022, “Portfolio Implications of a Higher US Inflation Regime” PGIM Quantitative Solutions White Paper. https://www.pgimquantitativesolutions.com/research/portfolio-implications-higher-us-inflation-regime
2 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.