CONSULTING RESEARCH GROUP | POSITION PAPER At CAPTRUST, we believe setting realistic capital market assumptions leads to more prudent asset allocation decisions for institutional and private wealth investors alike and to a more successful investment experience overall. In this year’s update to our assumptions, we look at the four principal themes of slower economic growth, low interest rates, monetary policy, and inflation over the five to seven years of our forecast period. The concept of normalization plays a central role in our thinking and could meaningfully impact asset class returns in the coming years. Financial literature has taught us that risk and return are related, and that optimized portfolios seek to produce the highest expected return per unit of risk. Formulating risk and return assumptions for the various asset classes that comprise capital markets offers investors a guide to the probable range of investment performance over a given period. These assumptions can then guide the asset allocation and risk levels that should be chosen to meet investment goals. Five years after the financial crisis, central bank policies remain 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, we expect a normalization of these factors as central bankers unwind their policies in response to improving growth and inflation, and interest rates gradually rise towards longer-term equilibrium levels. SUMMARY capital market assumptions The Long Road Toward Normalization May 2014 www.captrustadvisors.com
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consulting research group | position paper
At CAPTRUST, we believe setting realistic capital market
assumptions leads to more prudent asset allocation decisions
for institutional and private wealth investors alike and to a more
successful investment experience overall. In this year’s update to
our assumptions, we look at the four principal themes of slower
economic growth, low interest rates, monetary policy, and inflation
over the five to seven years of our forecast period. The concept
of normalization plays a central role in our thinking and could
meaningfully impact asset class returns in the coming years.
Financial literature has taught us
that risk and return are related,
and that optimized portfolios seek
to produce the highest expected
return per unit of risk. Formulating
risk and return assumptions for the
various asset classes that comprise
capital markets offers investors
a guide to the probable range of
investment performance over a
given period. These assumptions
can then guide the asset allocation
and risk levels that should be
chosen to meet investment goals.
Five years after the financial
crisis, central bank policies remain
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,
we expect a normalization of
these factors as central bankers
unwind their policies in response to
improving growth and inflation, and
interest rates gradually rise towards
longer-term equilibrium levels.
SUMMARY
capital market assumptions The Long Road Toward Normalization
May 2014
www.captrustadvisors.com
2 www.captrustadvisors.com
CAPTRUST FINANCIAL ADVISORS
capital market assumptions The Long Road Toward Normalization
overall, our new return forecasts are similar to our prior forecasts (published in april 2013) for most
asset classes, with several exceptions. historically low interest rates drive our subdued fixed income
returns, most notably in interest-rate-sensitive subsectors such as long-term treasurys, investment
grade corporate bonds, and mortgage-backed securities. a pick up in economic growth could aid equity
returns, although higher valuation levels provide a headwind, particularly for u.s. stocks. Despite lower
return forecasts across most asset classes compared to their long-term historical averages, we remain
generally constructive on capital markets.
GuidinG THemes Our forecast covers a full market cycle, typically a five- to seven-year period.
We look at four principal themes that guide our current thinking in formulating
capital market assumptions:
slower economic GrowTH
In recent years, growth has been held back by several factors, including corporate
and household deleveraging — or lessening reliance on debt — but that process
appears to be nearly complete. As shown in Figure One, the household and
financial sectors have made considerable strides in reducing their debt burdens;
debt-to-gross-domestic-product (GDP) ratios for both of these sectors are at
decade lows. Debt ratios for the corporate sector have steadily increased, but
high cash levels on corporate balance sheets are providing support. In contrast to
private sector deleveraging, government debt as a percentage of GDP continues to
increase at a rapid pace and is currently at historic highs. Fiscal tightening through
consulting research group | position paper
3capital market assumptions: The Long Road Toward Normalization
tax increases and spending cuts necessary to address the
government borrowing issue provided a headwind for U.S.
economic growth in recent years. However, we expect less
fiscal drag going forward, as these tax and spending measures
have significantly improved the U.S. federal budget deficit.
In our forecasts’ early years, we expect U.S. economic
growth to benefit from acceleration in the private sector
and reduced fiscal drag. In this environment, U.S. GDP
growth could finally break above the sluggish 2 percent level
witnessed since the 2008 financial crisis and possibly reach
3 percent growth for several years. Within the private sector,
homebuilding is beginning to recover and should boost
economic growth. In addition, consumer spending continues
at a solid pace as low inflation provides a quasi-tax cut for
U.S. consumers.
In our forecasts’ later years, GDP growth will likely return to a
more normalized level below 3 percent. Structural issues related
to the financial crisis, such as longer-term debt reduction and a
persistently high unemployment rate, may impact longer-term
growth. Demographic factors, such as an aging U.S. population,
could also play a role as the pace of labor force growth slows.
low inTeresT raTes U.S. interest rates have steadily fallen over the past thirty years
to historically low levels. In our forecast horizon’s early years,
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 towards their equilibrium level.
While the Fed is expected to keep short-term rates anchored in
the near term, it has less direct control over longer-term rates.
As U.S. economic momentum has improved over the past year,
longer-term interest rates have risen, although they remain
low by historical standards. In addition, the Fed has begun to
wind down its bond purchase program in light of an improving
labor market, a process that it will likely complete by year-end
2014. This action could also put some upward pressure on
longer-term interest rates. We expect interest rates to gradually
increase in the coming years to reach an equilibrium level more
consistent with history in the latter part of the forecast horizon.
As discussed later in this report, we expect subdued returns in
fixed income as this normalization process unfolds, since bond
prices move in the opposite direction of rates.
so
urce
: Fed
eral
res
erve
100%
80%
40%
140%
0%
120%
20%
60%
Figure One: Debt Outstanding by Sector as a Percentage of U.S. GDP, 1966–2013
Financial
household
corporate
government
1970 1975 1985 1995 20051980 1990 2000 2010
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CAPTRUST FINANCIAL ADVISORS
www.captrustadvisors.com
moneTary Policy
With fiscal policy constrained in the developed world,
monetary policy is a critical asset class return determinant.
In some cases, such as with global equities, monetary policy
could distort asset prices as investors pay less attention to
corporate earnings and other fundamental factors. 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’ ability to
successfully unwind their accommodative policies could have
significant asset price implications.
inFlaTion
U.S. inflation, as measured by the Personal Consumption
Expenditures Index (the Fed’s preferred measure) shown in
Figure Two, has been contained in recent years due to sluggish
GDP growth and considerable slack in the economy, which
have kept wage growth at low levels. Inflation is currently
running well below the Fed’s 2 percent target, and we expect
it to remain subdued in the near term. In the later years of our
forecast horizon, inflation is expected to be roughly in line with
the Fed’s target due to the impact of accommodative monetary
policy and stronger economic growth.
Some observers are concerned that the aggressive steps taken by
central banks could eventually lead to higher inflation. The Fed
significantly expanded its balance sheet following the financial
crisis, driven by purchases of U.S. Treasurys and mortgage-
backed securities. While higher-than-expected inflation is still a
possibility in the latter part of the forecast horizon, we see little
evidence to support this concern at the moment.
These four themes could have a significant impact on asset
class results during our forecast horizon. If private sector
growth continues to accelerate and fiscal drag diminishes, U.S.
GDP growth may finally break above the 2 percent threshold.
The future path of interest rates is meaningful to our forecasts,
particularly for fixed income. If longer-term rates stay low for
an extended period, this could be supportive for fixed income
returns. In contrast, if rates normalize faster than expected
due to acceleration in economic growth, fixed income returns
could be adversely impacted. Accommodative monetary policy
continues to be supportive of traditionally riskier asset classes,
but central banks will eventually face challenges as they
so
urce
: Blo
om
ber
g
Figure Two: U.S. Personal Consumption Expenditure Inflation, 1964–2018