Our longer-term asset class forecasts are forward-looking estimates of total return generated through a combined assessment of current valuation measures, economic growth, inflation prospects and yield conditions as well as historical risk premia. We also include shorter-term return forecasts that incorporate output from our multi-factor tactical asset allocation models. Outlined below is the process we use to arrive at our return forecasts for the major asset classes.
The starting point for our nominal asset class return projections is an inflation forecast. We incorporate both estimates of long-term inflation and the inflation expectations implied in current bond yields. US Treasury Inflation-Protected Securities (TIPS) provide a market observation of the real yields that are available to investors. The difference between the nominal bond yield and the real bond yield at longer maturities furnishes a marketplace assessment of long-term inflation expectations.
Inflation was a hot topic throughout the second quarter after Bloomberg Businessweek ran an April cover story titled “Is Inflation Dead?”, as core inflation readings in developed markets have spent the best part of the last decade at or below 2.0%. The US Federal Reserve’s (Fed’s) preferred inflation gauge, the personal consumption expenditures price index (PCE), registered a 1.5% annual increase in May and continues to languish below the Fed’s 2.0% target. Fed Chair Jerome Powell noted that the inflation undershoot may be more persistent than the Fed had hoped, causing Fed officials to lower this year’s outlook for headline PCE inflation and core PCE inflation to 1.5% and 1.8%, respectively. While realised inflation has firmed over the past three months on strength within the services and durable goods sectors, market-based inflation expectations measured by the five-year breakeven moved sharply lower during the quarter, particularly during May’s escalation in trade tensions. The negative trade sentiment sent the five-year breakeven to a new year-to-date low of 1.4% on June 17, below the levels seen during December’s equity market rout. Breakevens then rebounded along with oil prices and renewed trade optimism in the final week of June.
Our long-term forecasts for global cash returns incorporate what we view as the normal real return that investors can expect to earn over time. Historically, cash investors have earned a modest premium over inflation but we also take current and forward-looking global central bank policy rates into consideration in formulating our cash forecast. Our long-term cash return forecast is 2.7% for Canada and 2.5% % for the US, providing a slight premium over inflation. However, current monetary policy priorities in many non-US developed countries are dictating that cash returns stay below expected inflation rates. To this end, our long-term cash return for the eurozone is 1.5%, reflecting a discount on our long-term inflation projections. Our long-term forecast for the US has come down by 25 bps from the previous quarter. Our long-term cash return forecast for the eurozone has remained unchanged and so has the forecast for UK, while the short-term cash forecast has decreased by 10 bps for both. Our short-term return forecasts for cash are derived from expected policy rates.
Our return forecasts for fixed income are derived from current yield conditions together with expectations as to how real and nominal yield curves will evolve relative to historical precedent. We then build our benchmark forecasts from discrete analysis of relevant maturities. For corporate bonds, we also analyse credit spreads and their term structures, with separate assessments of investment-grade and high-yield bonds.
1,2 Factset 06/30/2019.
3 Phalippou, Ludovic and Olivier Gottschalg, 2009, “the Performance of Private Equity Funds”. Review of Financial Studies, vol. 22, no 4 (April) : 1747–1776.
4 Kaplan, Steven N, and Antoinette Schoar. 2005. “Private equity Performance: Returns, Persistence and Capital Flows.” Journal of Finance, vol. 60, no 4 (August): 1791–1823.
5 Robert Harris, Tim Jenkinson, and Steven Kaplan. 2014. “Private Equity Performance: What Do We Know?” Journal of Finance, vol. 69, no 5: 1851-1882