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, 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.
Global inflation slowed down in the first quarter of 2019, with US headline inflation falling from a 2.2% year-on-year change in November to 1.5% in February. Consumer price inflation remained muted across advanced economies, given the drop in commodity prices. For most countries in this group, core inflation is well below central-bank targets despite the pickup in domestic demand in the past two years; in the US and UK, it is close to 2%. Although wage growth has been picking up across most advanced economies, notably in the US and UK, it is still sluggish despite lower unemployment rates and diminished labour market slack.
While 2019 started out on a weak footing, a pickup is expected in the second half of the year. This pickup is supported by significant policy accommodation by major economies, made possible by the absence of inflationary pressures despite closing output gaps. The US Federal Reserve, in response to rising global risks, paused interest rate increases and signaled no increases for the rest of the year. The US 10-year break-even rate increased to 1.88% compared to a yield of 1.73% at the end of last year. The 15 basis-point quarterly increase in break-even yields coincides with a 45 basis-point quarterly decrease in real yields to 0.53% and a 28 basis-point drop in nominal 10-year yields to 2.41% for the quarter. We believe that such headwinds are temporary and that market-implied expectations will revive. Hence our current US long-term forecast for inflation remains in line with the central bank target of 2%.
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 2.75% for the US and 2.2% for the UK, 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 and short-term cash forecast for the US has remained unchanged from the previous quarter. Our long-term cash forecast for the eurozone has remained unchanged and so has the forecast for UK, while the short-term cash forecast has decreased by 10 basis points for both the eurozone and the UK. Our short-term forecasts for cash returns derive from observed policy rates. We expect short-term interest rates will normalise, but without certainty on the timing.
Basis Point (bps) A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
Bloomberg Barclays U.S. Corporate High Yield Index A fixed-income benchmark of US dollar-denominated, high-yield and fixed-rate corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays’ emerging markets country definition, are excluded.
Book to Price (B/P) Ratio A valuation metric that takes the ratio of the book value of a company per share to its share price.
Commodities A generic, largely unprocessed, good that can be processed and resold. Commodities traded in the financial markets for immediate or future delivery include grains, metals, and minerals.
Credit Spreads The spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating.
Dividend Equities and Dividend Yield Equity securities that pay dividends. A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. Dividends can be issued as cash payments, as shares of stock, or other property. Equity, also known as stock, is a type of security that signifies ownership in a corporation and represents a claim on part of the corporation’s assets and earnings. The dividend yield is the ratio of the dividend paid per share of issued equity over the share price.
Inflation An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
MSCI World Index The MSCI World Index is a free-float weighted equity index. It includes about 1,600 stocks from developed world markets, and does not include emerging markets.
Nominal Bond Yield The annual income that an investor receives from a bond divided by the par value of the security. The result, stated as a percentage, is the same as the rate of interest the security pays.
Price-to-Earnings Multiple, or P/E Ratio A valuation metric that uses the ratio of the company’s current stock price versus its earnings per share.
Private Equity An umbrella term for large amounts of money raised directly from accredited individuals and institutions and pooled in a fund that invests in a range of business ventures.
Real Interest Rates, or Real Yields An interest rate that takes into consideration the actual or expected inflation rate, which is the actual amount of yield an investor receives. The real rate is the calculation of the “nominal” interest rate minus the inflation rate as follows: Real Interest Rate = Nominal Interest Rate — Inflation.
REITs (Real Estate Investment Trusts) Publicly traded companies that pool investors’ capital to invest in a variety of real estate ventures, such as apartment and office buildings, shopping centers, medical facilities, industrial buildings, and hotels.
Tactical asset allocation models Illustrate a dynamic approach to asset management that emphasises exposure to asset classes that are designed to enhance returns or control drawdowns.
Smart Beta A rules-based investment strategy that seeks to capture specific factors in the marketplace that active managers have historically relied on to outperform. These include value, size, low volatility, quality and momentum.
US 3 Month Libor (Cash) Libor, or the London Interbank Offered Rate, is equivalent to the federal funds rate, or the interest rate one bank charges another for a loan. It is used as a reference figure for corporate financial transactions and, increasingly, for consumer loans as well.
Yield Curve (e.g., US Treasury Curve) A graph or line that plots the interest rates or yields of bonds with similar credit quality but different durations, typically from shortest to longest duration. When the yield curve is said to be “flat,” it means the difference in yields between bonds with shorter and longer durations is relatively narrow. When the yield curve is said to be “steep,” it means the difference in yields between bonds with shorter and longer durations is relatively wide.