Long-Term Asset Class Forecasting at State Street Global Advisors
State Street Global Advisors’ strategic asset allocation recommendations for our clients are dependent on the long-term assumptions we make about future risks and returns of portfolio components. These assumptions inform our portfolio decisions and, because of that, are crucial to the success of the investment process. The purpose of this paper is to provide a high-level summary of State Street’s long-term asset class forecasting approach, innovation, and advantages.
Asset class returns can vary substantially through a business cycle, and a given asset class may have negative short-term return expectations (because of short-term obstacles) while still having overall positive return expectations over the medium or long term. As a result, State Street’s long-term asset class forecasts (LTACF) must explicitly incorporate both short- and long-term investment horizons with potentially diverging outcomes.
A key component of our strategic asset allocation process is the need to be forward-looking in the inputs used. While this brings a level of uncertainty into the process as with any forecast, it does give a better perspective on how markets are likely to behave and influence the ability of investors to meet their goals. And while historical price patterns serve as a guide for the future “equilibrium value” of asset prices, in most cases we utilize some forward-looking indicators. Such indicators may be based on views of our economists, aggregated views of the Street’s analysts, or our collective conjectures about future asset price behavior that we believe will come to pass.
Finally, our forecasts highlight the relative attractiveness of asset classes. For example, when we see 10 year bond return forecasts projected to be low or negative, we know that investors will need to consider assets further along the risk spectrum to achieve desired returns. Risk-return analysis per asset class also guides us in portfolio construction, highlighting which asset classes are eligible for inclusion given a client’s desired risk and return objectives.
Building Blocks Approach to Return Forecasting
We use a “building blocks” approach to return forecasting, focusing on drivers that have an inner frequency commensurate with the time horizon of the forecast. For example, when formulating forecasts for the next 5 or 10 years, we use building blocks that include 10 year growth and inflation views, as well as long-term historical averages for term premia and price multiples.
Future equity returns are calculated as a sum of our expectations for earnings growth, inflation, and income (equity dividends). The final forecast also includes a correction reflecting the propensity of earnings multiples to mean-revert over the long term—see Figure 1. Dividends and growth prospects are the foundation of this analysis as their combination is a known starting point for expected returns. A blend of current and forward dividend yields can be used to estimate income return to be received by equity holders. Real earnings growth will drive market valuations, and inflation adjusts to create a view on nominal growth. Finally, the experience of equity investors is highly influenced by the level of valuation at the time of purchase, especially at extreme price multiples relative to historical levels. As such, we will make adjustments for potential multiple expansion or contraction going forward.