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.
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.
Fixed Income: The rapid rise in global sovereign interest rates in 2022 paused in the fourth quarter as a moderation in inflationary pressures resulted in interest rate markets pricing a less aggressive pace of policy tightening for global central banks in 2023. Our long-run forecast for hedged Global Aggregate Bonds is 5.0%, a modest decrease from the fourth quarter 2022 forecast of 5.1%, but up from just 1.3% from the first quarter of 2022. Our long-run forecast for US Aggregate Bonds is 4.3%, 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 4.2%, which is about 20 basis points lower than the midpoint of the policy rate target range at the end of 2022. Outside the US, developed market central banks are forecast to continue to increase policy rates, as longer-run policy normalization is expected. In US credit markets, we are forecasting average spreads will be comparable over the next 10 years to those prevailing at the end of 2022, informing expected returns of 4.9% and 6.1% 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 2.6%.
Private Assets: 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 0.5% for the Australian dollar to a gain of 1.3% for the Japanese yen. Forecast outcomes for emerging market currencies range from an expected loss of 2.6% for the South African rand to a gain of 0.8% 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 7.2% annually over the next 10 years. This forecast represents a material increase over our forecast of 4.4% from the first quarter of 2022, attributable to both the rise in global interest rates 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.