2023 Q1 Capital Market Assumptions2023Q1CapitalMarketAssumptions

Overview

Amid dramatic tightening by global central banks yet positive economic and earnings growth in 2022, the multi-asset team slightly lowered its capital market forecasts:

• More favorable valuations following the strong advance of Global Equities in Q4 2022 led to a modest decrease in the team’s long-term forecast for the asset class from 8.5% to 8.0%.
• The rapid rise in global interest rates in 2022 paused in the fourth quarter as a moderation in inflationary pressures resulted in markets pricing a less aggressive pace of policy tightening in 2023, leading to a forecast of 5.0% for Global Aggregate Bonds, a slight downward revision from the fourth quarter.
• The team’s long-term forecast for a balanced portfolio (60% Global Equities unhedged/40% Global Aggregate Bonds hedged) is therefore 7.2%, a decrease of 0.4% from the fourth quarter of 2022.

Summary

Q4 2022 Developments Informing Our Long-Term (10-Year) Forecasts: The global economy was plagued by persistently high inflation in 2022, prompting dramatic tightening by global central banks in an attempt to bring inflation under control. Russia’s invasion of Ukraine led to a surge in energy prices, further exacerbating inflation and making the task of central banks even more difficult. Inflation is likely to have peaked in late 2022 as lower commodity prices and easing supply chain bottlenecks appear to have pushed inflation lower. Although economic and earnings growth stayed positive for the year amid moderating inflation, forecasters expect this to possibly change in 2023, especially in Europe. Nevertheless, GDP and earnings expectations in the US remain positive, albeit with the possibility of a short-lived and minor recession in the latter half of the year. Major central banks retained hawkish positions at the close of the year, and signaled they are unlikely to pivot until there are clear signs that inflation is sustainably slowing toward targets, elevating the risks of policy mistakes among banks in developed markets. Market pricing currently reflects a slower pace of hiking, which will continue to drive short-term interest rates higher. However, on the back of lower inflation expectations, and speculation that the US Federal Reserve (Fed) may pivot, long-term rates trended lower in the latter half of the year, and the Treasury yield curve definitively inverted across various key rates. While an inverted yield curve has long been associated with economic recessions, Fed chair Jerome Powell highlighted that in this case the inversion may represent a successful fight with inflation. For the US, consensus mean forecasts for 2022 and 2023 call for 1.9% and 0.2% real GDP growth and 8.1% and 4.1% CPI inflation, respectively. The Bloomberg Commodity Total Return Index advanced by 2.2% in the fourth quarter of 2022. Gains of 16.4% and 13.3% in Industrial and Precious Metals sub-indexes, respectively, for the quarter were mostly offset by a -9.1% decline in the Energy sub-index. For 2022, the Bloomberg Commodity Index advanced 16.1%. 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 similar to those from the previous quarter. Evolving policy rates and 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 2022. Nevertheless, inflation is expected to be somewhat higher than that observed in the period following the Global Financial Crisis (GFC) 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 than in developed markets. 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 6.5% in 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 8.0%, a decrease from our forecast of 8.5% for the fourth quarter of 2022. The forecast decrease is primarily attributable to more favorable valuations following a 9.9% advance in Global Equities in the fourth quarter, reducing year-to-date losses to a still substantial -18.7%. Our long-term return forecast for US Equities is somewhat lower, at 7.3%. Looking at the rest of the world, Developed Market Equities outside the US are forecast to return 9.3% and Emerging Market Equities are forecast to return 9.5% over the next 10 years. 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.