At the end of 2020, uncertainty surrounding the near-term economic outlook remained elevated, as a second wave in new virus cases in the US and Europe at the onset of winter increased the likelihood that renewed virus containment measures would challenge the nascent global economic recovery. These events influenced QMA’s long-term asset class forecasts in their Q1 2021 Capital Market Assumptions (CMAs), which provide 10-year expectations for the most widely held equity, fixed income and non-traditional asset classes. They are the product of a highly systematic process for generating consistent projections across the capital markets, underpinning the team’s long-run outlook for strategic allocations in multi-asset portfolios.
Vaccination Efforts Promote Economic Activity
Based on their forward-looking views of economic growth and inflation for 16 nations, QMA forecasts the global economy to rebound strongly in the near term, while long-term growth continues to moderate. Expectations are for a surge in the second half of 2021 as vaccination efforts to control the COVID-19 pandemic allow for a wider range of economic activity.
Longer-term economic growth in developed economies is expected to be led by Australia and other countries with younger populations and more liberal immigration policies. Labor forces are expected to contract in Japan and parts of Western Europe where growth is slowest. Inflation in developed markets to increase modestly over the next decade, ranging from a forecast 2.2% annual rate in Australia to a low of 0.9% in Japan. Emerging markets, however, are expected to produce real economic growth and inflation at annualized rates of 4.6% and 2.5%, respectively, driven by younger populations and higher rates of return on capital.
Figure 1: 10-Year Forecast Returns and Volatility
Source: QMA as of 12/31/2020. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this document.
Evolution of Market Outlook
Economic expansion in the US ended abruptly in the first quarter of 2020. Lasting 126 months, it was the longest expansion in the postwar period, if also one of the weakest, as measured by average real GDP growth. Against this backdrop, equity markets performed strongly, with the MSCI World Index delivering annual returns of 11.1% in the 10-year period following the end of the last recession through the end of 2019. US equities fared even better, with the S&P 500 Index advancing at a 14.5% annualized rate.
In contrast, QMA’s long-term capital market assumptions for global equities over the last decade have gradually come down, unchanged from last quarter at 6.4%. Forecasts for global fixed income assets have also declined broadly over the last 10 years, primarily attributable to historic declines in underlying sovereign interest rates and an estimated $17 trillion in negative-yielding debt as of December 31, 2020.
Long-term equity forecasts include income, growth and value considerations.
Consistent with historical precedent and assuming the continuation of current dividend taxation regimes, we expect US income returns coming from share buybacks, equal to about 1.9% in QMA’s long-term forecasts. Outside of the US, the expected impact of net buybacks in developed is anticipated to be a much more modest 0.1%. For emerging markets, an expected drag on income returns from net share issuance is forecast at 0.7%.
QMA’s growth and inflation assumptions have been adjusted higher from the previous quarter along with forecasts that the global economy will rebound from the COVID-19 downturn. The 10-year forecast for US real annualized GDP growth is now 2.1%, with 2.2% for inflation translating to an earnings growth component of 4.3%. In developed markets outside the US, the 10-year expectation for real GDP growth is 1.8%, while inflation is expected to average 1.4%, providing nominal earnings growth of 3.2%, an increase of 0.9% from our forecast the previous quarter. Higher nominal GDP growth in emerging markets relative to developed markets is expected to result in long-run nominal earnings growth of 7.1%.
Less attractive valuations resulted in a net negative adjustment for global equities in general since the end of the third quarter. Among developed markets, the US maintains a negative expected long-term valuation adjustment of -1.8% annually, attributable to historically elevated valuation ratios. Developed equities outside the US, in contrast, are expected to benefit by 0.7% annually, given what are relatively cheap historical valuation ratios. Emerging markets equity returns are forecast to be 0.5% per year lower on negative valuation adjustments.
Global Fixed Income
Yields for the US Treasury Index are expected to rise modestly over the next 10 years, resulting in a negative valuation adjustment and an expected return of 0.9%, an increase of 0.1% from the end of the third quarter.
Developed market government bonds outside the US are forecast to return less over the next decade, given lower initial yields and a negative valuation adjustment, as yields are expected to rise over the forecast horizon. Long-run returns in non-US global developed market government bonds for a US investor are forecast at 0.7% on an unhedged basis and 0.3% on a hedged basis, given the differentials in forecast short-term interest rates.
Real Assets Positioned to Perform Well
QMA’s Global Multi-Asset Solutions team restored positive expectations for REITs in the first quarter of 2021. Their outlook for the sector is much improved, with an assumption that a good portion of the adjustment in dividends has played out. Long-run forecasts for US and global REITs are now 6.8% and 6.7%, respectively.
The team anticipates returns of 1.4% in commodities, primarily attributable to an increased expected spot return over cash premium. Rounding out real assets, US TIPS are expected to return 1.0%, unchanged from last quarter.