Despite two quarters of negative GDP growth in the US and expectation of moderating long-term economic growth in other developed economies, the multi-asset team raised its capital market forecasts:
- Declining equity markets and subsequent improvement in valuations in 2022 along with higher longer-term inflation expectations elevated the long-run forecast for Global Equity returns to 8.5%.
- Expectations of continued global central bank interest rate hikes to address high inflation led to a forecast of 5.1% for hedged Global Aggregate Bonds, a material upward revision from the second quarter’s forecast of 3.9%, and up from just 1.3% from the first quarter of 2022.
- The team’s long-term forecast for a balanced portfolio (60% Global Equities unhedged/40% Global Aggregate Bonds hedged) is therefore 7.6%, an increase of 1.0% from the second quarter.
Q3 2022 Developments Informing Our Long-Term (10-Year) Forecasts: The most recent estimates of US GDP showed the economy shrank by -0.6% during the second quarter of 2022 amid a continued reduction in inventories and residential investment, marking a second-consecutive quarter of negative growth. Despite the negative reading domestic demand held firm. Labor market strength, driven by ongoing growth in non-farm payrolls in July and August and low unemployment, continued to support consumption spending. Still, other areas of the global economy struggled. This was most evident in Europe where many economies are likely to enter recessions this winter amid a sharp surge in natural gas prices that weighed on households and businesses. Supply shortages, along with higher energy costs, also led to manufacturing shutdowns and deteriorating business confidence. Meanwhile in China, industrial output, retail sales and fixed asset investment improved marginally in the most recent quarter following significant weakness earlier in the year. Federal Reserve (Fed) Chair Powell’s speech at the Jackson Hole symposium in August emphasized the importance of doing whatever it takes to bring inflation down, boosting expectations for further Fed rate hikes. Powell argued that bringing inflation back to the 2% target is crucial, even if it causes economic pain or a hard landing. He also warned against prematurely loosening policy. The Bloomberg Commodity Total Return Index declined by 4.1% in the third quarter of 2022, reducing total year-to-date gains to a still impressive 13.6%. Our near-term developed and emerging market economic growth forecasts for the next 10 years have declined slightly, while our inflation forecasts for the same horizon are somewhat higher than 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 8.2% through the first three quarters 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 8.5%, an increase from our forecast of 7.7% for the third quarter of 2022. The forecast increase is primarily attributable to more favorable valuations following a 6.7% decline in Global Equities in the third quarter, taking year-to-date loses to 25.3%. Our long-term return forecast for US Equities is somewhat lower, at 7.8%. Looking at the rest of the world, Developed Market Equities outside the US and Emerging Market Equities are both forecast to return 10% over the long-run. Cheaper valuations, as measured by historical valuation ratios, are driving stronger expected returns for non-US Developed Market Equities versus US Equities. While faster expected economic growth is a positive for Emerging Market Equities versus non-US Developed Market Equities, it is offset by relatively less attractive valuations and income growth.
Fixed Income: Global sovereign interest rates continued to rise markedly in the third quarter of 2022 as inflationary pressures prompted a ratcheting up in expectations for further global central bank interest rate hikes. Our long-run forecast for hedged Global Aggregate Bonds is 5.1%, a material upward revision from the second quarter’s forecast of 3.9%, and up from just 1.3% from the first quarter of this year. Our long-run forecast for US Aggregate Bonds is 4.7%, with the lower expected return relative to the Global Aggregate mostly attributable to a positive contribution from hedging foreign currency exposure. At the end of our 10-year forecast horizon, we expect the US Fed’s policy rate to be approximately 3.8%, which is about 70 basis points higher than the midpoint of the policy rate target range at the end of the third 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 over the next 10 years from the elevated levels witnessed at the end of the third quarter following a meaningful rise through the first three quarters of 2022, informing expected returns of 5.5% and 7.0% 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 expected to outperform our 10-year US inflation forecast of 2.7%.
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 forecasts for US Buyout Private Equity, US Venture Capital Private Equity and US Mezzanine Private Debt are linked to the forecast outcomes of public market assets with a premium consistent with historical empirical outcomes, acknowledging the underlying illiquidity and potential leverage employed in these asset classes relative to public market counterparts. Our forecasts for Core and Opportunistic US Private Real Estate are based on inputs from the NCREIF Property Indexes and linkages to forecast US 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 0.6% 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 2.5% 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 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 7.6% annually over the next 10 years. This forecast represents a material increase of 1.0% 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, 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.