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Capital Market Assumptions

The Long Road Toward Normalization

Hunter Brackett, CFA®
CAPTRUST Senior Manager | Consulting Research Group

At CAPTRUST, we believe setting realistic capital market assumptions leads to prudent asset allocation decisions. In this annual forecast update, the concept of normalization plays a central role in our thinking and could meaningfully impact asset class returns in coming years. Five years after the financial crisis, central bank policy remains accommodative, interest rates are still near historical lows, inflation remains contained, and economic growth is below its long-term trend. However, over the five- to seven-year horizon of our forecast (the length of a typical full market cycle) we expect these factors to normalize as central bankers unwind their policies in response to improving growth and inflation, and interest rates gradually rise toward longer-term equilibrium levels. Four principal themes guide our current thinking as we formulate capital market assumptions:

1. Slower Economic Growth 

Deleveraging has been a primary cause of the current shallow recovery compared to prior economic cycles. However, the private sector’s debt burden shows marked improvement, and the U.S. federal deficit has narrowed due to fiscal tightening in recent years. In the early part of our five- to seven-year forecast, U.S. gross domestic product (GDP) growth could finally break above the sluggish 2 percent level witnessed since the 2008 financial crisis, due to growth acceleration in the private sector and reduced fiscal drag (as a result of increased taxes and less government spending). In our forecast’s later years, GDP growth will likely return to a more normalized level, between 2 and 3 percent.

2. Low Interest Rates 

In the early part of our five- to seven-year forecast, we expect the Federal Reserve to keep short-term interest rates at the present low levels, depending on the overall economy’s trajectory. In the later years, the Fed will likely gradually raise short-term interest rates toward their equilibrium level. As U.S. economic momentum has improved over the past year, longer-term interest rates have risen, although they remain low by historical standards. As the Fed winds down its bond purchase program in light of an improving labor market, this could also put some upward pressure on longer-term interest rates.

3. Monetary Policy 

With fiscal policy constrained in the developed world, monetary policy is a critical return determinant. Developed market monetary policy is expected to remain accommodative in the near term given subdued inflation and considerable slack in most economies. As growth and inflation expectations normalize in the coming years, central banks’ abilities to successfully unwind accommodative policies could have significant asset price implications.

4. Inflation 

Inflation has been contained in recent years due to sluggish GDP growth, which has kept wage growth at low levels. Inflation is currently running well below the Fed’s 2 percent target; we expect it to remain subdued in the near term. In the later years of our forecast, we expect inflation roughly in line with the Fed’s target, due to accommodative monetary policy and stronger economic growth.

Figure One shows that our new return forecasts are similar to prior forecasts for most asset classes, with some exceptions. When developing capital market assumptions, the starting point for each asset class is an important consideration since it historically has a high correlation with future returns. Historically low interest rates drive our subdued fixed income return expectations, most notably in interest-rate-sensitive subsectors such as long-term Treasurys and core fixed income. Equity valuations have rebounded in recent years, which suggests a lower probability of multiple expansion (investors paying a higher price per unit of earnings) going forward.

Our new risk forecasts are modestly lower than our prior forecasts across most asset classes. We use standard deviation — which measures the possible divergence of the actual return for an asset class from its expected return — as one risk metric. Over the past five years, the deleveraging process and other repercussions from the financial crisis drove increased volatility in economic growth and asset prices. With the deleveraging process largely complete, expected volatility should come to be more in line with longer-term averages.

Figure Two provides historical context for our return forecasts in certain asset classes. For most asset classes, our assumptions are below their historical returns, particularly for the prior five-year period in which accommodative monetary policy has been a primary market driver. Our fixed income return expectations are generally below historical returns as we enter a period of rising interest rates. Our equity return expectations are significantly below five-year historical returns as stocks have rebounded sharply off their 2009 lows. Among the alternative asset classes, we expect public real estate to post significantly lower returns compared to recent years, as this asset class benefited from lower interest rates.

An obvious question to ask is: What are the implications of CAPTRUST’s capital market assumptions on my portfolio’s expected return and risk? Figure Three attempts to answer this question with three hypothetical portfolios containing a diversified mix of asset classes. Clients will have a better chance to meet their long-term return objectives by increasing exposure to traditionally riskier asset classes such as equities; however, they must be willing to accept higher portfolio return variance. Our standard deviation assumptions for equities are considerably higher than fixed income, thus investors should incorporate this factor into asset allocation decisions. Note that the expected return and risk numbers shown in Figure Three are for illustrative purposes; actual results in a given year could differ materially from these forecasts.

Despite lower return forecasts across most asset classes — compared to their historical averages — we remain generally constructive on capital markets. Although we expect subdued returns for fixed income, we continue to believe that this asset class plays an important role in client portfolios. It has historically been a less volatile asset class and provided a cushion during times of economic stress. Nevertheless, investors will need to be more selective with their asset allocation decisions in fixed income. As economic growth prospects improve and monetary policy remains accommodative, traditionally riskier assets such as equities could provide solid returns over the forecast horizon. However, given their strong run over the past five years, equity valuations are stretched, which could create a modest drag on returns. We are less favorable on commodity returns due to slower global growth, although they could still play a role in portfolios as an inflation hedge. Real estate continues to have favorable market dynamics, but higher interest rates will likely be a headwind. Alternative assets such as private equity and hedge funds can benefit from individual manager skill and are often less correlated with traditional asset classes.

More in-depth information about our updated capital market 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. 

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