2023 Q3 Capital Market Assumptions2023Q3CapitalMarketAssumptions

Overview

Following more than a year of aggressive rate hikes, central banks appear on the verge of ending their tightening cycles as headline inflation declines. While recession risks remain, concerns may have eased modestly in the near term. For Q3 2023, the Multi-Asset team’s economic growth forecasts for the next 10 years are essentially unchanged. The inflation forecasts for the same horizon are also roughly unchanged for the US, but lower for Europe, higher for Japan, and mixed elsewhere.
 

• The long-term return forecast for Global Equities decreased to 7.3% due primarily to less favorable valuations following a 6.3% advance in Global Equities in the second quarter.
   
• Continued resilience in developed economies decreased near-term expectations that central banks would begin easing policy, sending global sovereign interest rates higher. The long-run forecast for hedged Global Aggregate Bonds is 4.2%, modestly higher than the second quarter 2023 forecast of 4.0%, due to this rise in sovereign rates.
   
• The team’s forecast for a balanced portfolio (60% Global Equities unhedged/40% Global Aggregate Bonds hedged) is 6.5% annually over the next 10 years, more than 2% higher than the forecast from the first quarter of 2022, prior to the commencement of the Fed's tightening policy. This material increase is attributable primarily to the rise in global interest rates over the last 18 months.

Summary

Q2 2023 Developments Informing Our Long-Term (10-Year) Forecasts: Following more than a year of aggressive rate hikes, central banks appear on the verge of ending their tightening cycles as headline inflation declines (although remains above target) with weaker energy costs and price increases from 2022 falling out of the calculation. While both the US Federal Reserve (Fed) and European Central Bank (ECB) raised policy rates in late July, in their respective press conferences Chair Powell and President Lagarde declined to commit to additional rate hikes later in the year. In response, markets moved from pricing one more Fed hike this year to leaving rates unchanged after the July meeting, although there is still some probability of either cuts or hikes later in the year. More likely, however, is a scenario in which the Fed remains on hold through the remainder of the year and then considers cutting rates in 2024, if inflation conditions permit. In contrast, the Bank of Japan announced more flexibility in its yield curve control program in late July, effectively allowing a higher upper range for the 10-year JGB yield to trade. Rate hikes over the course of Q2 and into early Q3 have contributed to modest upward pressure on 10-year yields in the US, but little changed in Europe. Yield curves remain inverted, which has historically preceded recessions in the US.

While recession risks remain, concerns may have eased modestly in the near term. The residual impact of COVID-related monetary and fiscal stimulus has kept demand robust, but the global growth outlook may be more tenuous over a longer horizon. In the US, GDP rose solidly in Q2 as the strong labor market helped the economy weather March’s regional banking crisis and May’s debt ceiling drama. European GDP growth strengthened in Q2 but grew at a weaker pace than in the US amid rising interest costs and weaker demand from China. Meanwhile, the Japanese economy received a tailwind in the first half of 2023 from the government’s ongoing easing of COVID restrictions. In contrast, China’s eagerly anticipated reopening has been uneven in the first half of 2023. With central bank hikes likely coming to an end, global equities extended their gains in Q2, rising over 6% and bringing year-to-date gains to over 14%. The strong performance of US equities helped underpin global returns but led valuations of US stocks to become more extended than those of non-US equities. Our economic growth forecasts for the next 10 years were essentially unchanged. Our inflation forecasts for the same horizon were also roughly unchanged for the US, but lower for Europe, higher for Japan, 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 extended 1970s-style, double-digit inflation appears unlikely, the potential for a sustained period of average inflation well above central bank targets, as it still stands today at 3.5%, 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 7.3%, a decrease from our forecast of 7.7% for the second quarter of 2023. The forecast decrease is primarily attributable to less favorable valuations following a 6.3% advance in Global Equities in the second quarter. Our long-term return forecast for US Equities is somewhat lower, at 6.6%. Looking at the rest of the world, Developed Market Equities outside the US are forecast to return 8.5% and Emerging Market Equities are forecast to return 9.2% 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.