Hunter Brackett, CFA®
Senior Manager | CAPTRUST Consulting Research Group
Since the financial crisis, the massive intervention of governments in the developed world has overwhelmed normal market forces. Monetary policy, rather than fiscal policy or fundamental factors such as corporate earnings, has been the driving force behind capital markets. The result has been slower economic growth, historically low interest rates, and contained inflation. These traits have characterized the economic environment of the past several years. But how does where we are today — economically speaking — influence how we should be thinking about the future?
CAPTRUST recently completed an extensive research project as part of an effort to answer this important question. The result of this work is a set of asset class return and risk assumptions for the next full market cycle, a period of five to seven years (based upon historical definition). We divide this forecast period into two periods. In the first three years of our forecast, we foresee a continuation of slow growth — as measured by Gross Domestic Product (GDP) — low interest rates, and modest inflation. In years four through seven, we expect a gradual acceleration of GDP growth leading to higher inflation and interest rates.
Four principal themes guide our thinking for capital market assumptions. They are:
1) Slower economic growth. Deleveraging has been a primary cause of the current shallow recovery when compared to prior economic cycles. While the private sector’s debt burden shows marked improvement, the U.S. government’s debt-to-GDP ratio remains at a historically high level. In the early years of our forecast, we expect fi scal contraction to offset better private sector growth prospects. In the later years, both the public and private sectors could contribute to growth.
2) Low interest rates. Many investors are concerned that interest rates can only go higher from today’s historically low levels. The Federal Reserve may keep short-term rates at the present low levels for several more years depending on the pace of economic improvement. However, longer-term interest rates could rise gradually toward historical equilibrium levels.
3) Monetary policy. With fiscal policy constrained in the developed world, monetary policy becomes a critical factor in forecasting asset class returns. Central bank actions influence not only interest rates, but also investor behavior, as evidenced by strong flows into higher-yielding asset classes over the past year.
4) Inflation. Sluggish GDP growth and considerable slack in the economy have recently kept inflation in check. We expect inflation to remain subdued in the near term but pick up in the later years of our forecast due to the impact of accommodative monetary policy and stronger economic growth.
We foresee generally lower returns and higher levels of risk for most asset classes, primarily due to lower starting points across each asset class. Fixed income is perhaps the easiest asset class to demonstrate the impact of a low starting point. As Figure 1 shows, 10-Year U.S. Treasury yields have historically proven to be a good proxy for five-year forward returns for fixed income investments. If this relationship holds true, a 2% yield on the 10-Year Treasury at the start of 2013 could signal subdued fixed income returns in future years.
Following a multi-decade bull market in fixed income and facing the prospect of rising interest rates, it may be tempting for investors to abandon this asset class. However, we continue to believe that fixed income has an important role to play in client portfolios, as it provides a cushion during times of economic stress. Nevertheless, we expect subdued returns for fixed income going forward, so investors will need to be more selective with their asset allocation decisions in this area.
Slower economic growth adversely impacts equity returns. We use three building blocks to develop equity return assumptions — dividend yield, expected earnings growth, and the impact from valuation changes. While high cash levels on corporate balance sheets and a focus on returning capital to shareholders (including share buybacks) provide support for dividend yields, earnings growth could be significantly lower than historical averages as companies face pressure to grow revenue and further reduce costs. We do not model any valuation impact for most equity categories because they appear fairly priced based on price-to-earnings ratios. The net result of this analysis is reduced return assumptions and, in most asset classes, slightly elevated risk levels.
While alternative assets can benefit from individual manager skill and are often less correlated with traditional asset classes, the same four themes drive our following thinking:
• Nominal global GDP growth is used as a reasonable proxy for commodity returns. As with equities, slower global economic growth leads to lower commodity returns compared to our prior assumptions.
• To derive private equity returns, we add an illiquidity premium to our U.S. large-cap equity assumption.
• We use a multifactor model to identify the components of hedge fund returns. The model is largely driven by our cash forecast, which leads to a subdued return expectation for the broad hedge fund of funds category.
Figure 2 shows our new return assumptions, which are generally below prior assumptions. We also highlight our new risk assumptions, which, in most cases, are higher than prior assumptions. Increased volatility in economic growth and asset prices are by-products of the deleveraging process and could continue in coming years.
Despite our forecast of generally lower returns and higher levels of risk for most asset classes, we remain generally constructive on the capital market opportunity set. While economic growth prospects are not robust, traditionally riskier assets such as equities could still provide solid returns over our five to seven year forecast horizon. Equities do not appear inexpensive on an absolute basis, but they do look compelling relative to fixed income — subject to one’s risk tolerance and time horizon. The current low level of interest rates leads us to expect subdued fixed income returns, most notably in rate-sensitive subsectors such as long-term Treasurys and core fixed income. These factors lead us to believe that, as has been the case in recent years, investors will need to be selective with their asset allocation decisions.
More in-depth information about our revised capital market return and risk assumptions — and the methodology behind them — will be published in a forthcoming position paper. As always, if you have questions or would like additional perspective, please contact your CAPTRUST Financial Advisor.