2023 Q2 Capital Market Assumptions
Overview
The Multi-Asset team expects Developed Market inflation to trend lower and real economic growth to moderate over the next decade due to limited labor force growth. Real economic growth and inflation in Emerging Markets is expected to advance at higher annualized rates than in Developed Markets, driven by younger populations and higher rates of return on capital:
- The long-term return forecast for Global Equities decreased slightly to 7.7% from the first quarter of 2023 after equity market rallies led to less favorable equity valuation levels.
- Moderating inflation during the first quarter led markets to price in a less aggressive policy tightening by global central banks for the rest of the year. Declining yields and lower expected returns from hedging therefore led to a substantial decrease in the long-run forecast for hedged Global Aggregate Bonds.
- The team’s long-term forecast for a balanced portfolio (60% Global Equities unhedged/40% Global Aggregate Bonds hedged) decreased modestly to 6.6% but remains more than 2% higher than the forecast from the first quarter of 2022, prior to the commencement of the Fed's tightening policy.
Summary
Q1 2023 Developments Informing Our Long-Term (10-Year) Forecasts: The global economy started 2023 on an unexpectedly positive note. The US economy was on a strong footing, supported by a robust labor market and a reduced drag from high energy prices that peaked in mid-2022. Euro area growth held up better than anticipated over the winter, partly due to unseasonably warmer weather, while the Japanese economy benefited from improving consumption after the easing of COVID-related restrictions. In China, economic activity rebounded swiftly after the December 2022 relaxation of its extreme COVID lockdown policy. While Developed Market headline inflation continued to moderate as price shocks from Russia’s aggression in Ukraine began to fall out of the calculation, resilient labor markets and still-elevated services sector inflation kept major central banks on a tightening path. Toward the end of the first quarter of 2023, however, the failure of several US regional banks resulted in a substantial market reassessment of the future path of central bank policy. The US Federal Reserve (Fed) has the unenviable task of trying to engineer a further decline in inflation, still far above its 2% target, while simultaneously maintaining depositor confidence in a suddenly shaken banking system. After another round of hikes in late spring, many global central banks are expected to go on hold through the summer. Market pricing suggests that they will cut rates as soon as late 2023 and into 2024, but official communications so far suggests otherwise. Nevertheless, the impact is seen on movements in sovereign bond yields with short-term rates increasing and longer-term rates easing over the quarter. The inverted yield curve, across many different measures, suggests increased risks of a recession going forward. In spite of these risks, global equities performed well in Q1, rising over 7%, though valuations also became more expensive. Non-US stocks remain cheaper than US stocks. Our US economic growth forecast for the next 10 years is slightly higher than last quarter, while non-US developed growth forecasts are mixed and Emerging Markets forecasts are lower. Our inflation forecasts for the same horizon are higher for Japan, lower for Emerging Markets, and mixed elsewhere. 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 7.7%, a decrease from our forecast of 8.0% for the first quarter of 2023. The forecast decrease is primarily attributable to less favorable valuations following a 7.4% advance in Global Equities in the first quarter. Our long-term return forecast for US Equities is somewhat lower, at 7.0%. Looking at the rest of the world, Developed Market Equities outside the US are forecast to return 8.8% and Emerging Market Equities are forecast to return 9.3% 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 partially offset by relatively less attractive valuations and income growth.
Fixed Income: The rapid rise in global sovereign interest rates in 2022 reversed somewhat in the first quarter of 2023 as a moderation in inflationary pressures resulted in interest rate markets pricing a less aggressive pace of policy tightening for global central banks for the balance of 2023. Our long-run forecast for hedged Global Aggregate Bonds is 4.0%, a material decrease from the first quarter 2023 forecast of 5.0%, attributable to a decline in yields in the first quarter as well as a reduction in the expected returns from hedging. 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 Fed’s policy rate to be approximately 4.2%, which is about 70 basis points lower than the midpoint of the policy rate target range at the end of the first quarter of 2023. 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 4.5% and 5.6% 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 0.6% for the Australian dollar to a gain of 1.1% 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 1.0% 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 latest forecast is more than 2% higher than our forecast from the first quarter of 2022, prior to the commencement of the Fed's tightening policy. The material increase in this forecast is attributable to the rise in global interest rates over the last 15 months as well as to 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.