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.
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.
Fixed Income: Global sovereign interest rates resumed their ascent in the second quarter of 2023 as continued resilience in developed economies, led by the US, decreased near-term expectations that central banks would begin easing policy in response to an economic slowdown or further moderation in inflation. Our long-run forecast for hedged Global Aggregate Bonds is 4.2%, modestly higher than the second quarter 2023 forecast of 4.0%, due to the aforementioned rise in underlying sovereign rates. Our long-run forecast for US Aggregate Bonds is 4.3%, a slightly higher expected return relative to our forecast for Global Aggregate Bonds attributable to higher initial yields partially offset by 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 3.2%, which is about 200 basis points lower than the midpoint of the policy rate target range at the end of the second quarter of 2023. Outside the US, Developed Market central banks (aside from Japan) are forecast to continue to increase policy rates as inflation pressures remain elevated. In US credit markets, we are forecasting average spreads over the next 10 years will be comparable to those prevailing at the end of the second quarter of 2023, informing expected returns of 4.8% and 5.4% 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 generally negative returns for the US dollar relative to Developed Market peers, with outcomes ranging from an annualized loss of 0.1% for the Australian dollar to a gain of 0.9% for the Swiss franc. Forecast outcomes for Emerging Market currencies range from an expected loss of 2.7% for the South African rand to a gain of 0.9% for the Taiwan dollar. Long-term currency hedging returns against a market-weighted basket of Developed Market exposures are forecast to be net positive 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 6.5% 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 our forecast is attributable primarily to the rise in global interest rates over the last 18 months.
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.