2023 Long-Term Capital Market Assumptions: Back to basics
As asset return forecasts move closer to equilibrium, we discuss how today’s market offers the best returns in over a decade.
David Lebovitz: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is entitled, 2023 long-term capital market assumptions, back to basics, and has been recorded for institutional and professional investors.
I'm David Lebovitz, Global Market Strategist, and host of the Center for Investment Excellence. With me today is Michael Hood, Global Strategist from Multi-Asset Solutions at JPMorgan Asset Management. Welcome to the Center for Investment Excellence.
Michael Hood: Thanks for having me.
David Lebovitz: It's my pleasure. So, particularly excited for our conversation today, where we are going to be discussing our 27th annual long-term capital market assumptions. And we're going to talk a lot about what the combination of lower valuations and higher yields mean for the market going forward.
But without giving away the punchline, I would highlight that the return forecasts we pulled together, are some of the best potential long-term returns since 2010. So, and looking forward to very interesting conversation about what really drove that improvement.
But before we dive into the capital market side of things and the asset side of things, I always think it's good to level-set and have a conversation about how the growth and inflation numbers both have and have not changed. And when we think about the past couple of years, the pandemic turned the economy on its head.
Then earlier this year in 2022, dealing with Russia's invasion of Ukraine in Eastern Europe, we're now in this environment of persistent inflation, hawkish monetary policy. Michael, to start, what has the world today really meant for our views on long-term growth and inflation, and how has it impacted or not impacted the way we're thinking about economic activity and prices over the next 10 to 15 years?
Michael Hood: Thanks, David. On the growth side, there really hasn't been all that much change over the course of the last couple of years. You know, this is the third time we've done this exercise since the start of the pandemic, and in the immediate wake of the pandemic and the lockdowns and so on, there were all kinds of discussions about how different parts of the economy might look radically different going forward, people decamping from cities, nobody going to offices, all kinds of significant changes.
And that first year, we didn't feel like we had enough information to incorporate any of that. By the time we got to the second year, a lot of those forces really seemed to be fading. And if anything, we actually did a little bit of an upward nudge to some of the long-term growth projections last year, because we got a little bit more optimistic about long-term productivity growth.
Again, some of that was catalyzed by investment tech adoption that we saw that was really fueled by the pandemic. And then coming into this year, again, still not seeing a lot of evidence that those big, long-term changes to the global growth outlook, whether that be deglobalization or deurbanization, are really taking hold.
And this year, we're a little bit less enthusiastic about boosting that productivity outlook further, after what's been a disappointing year of outcomes on that front. So, really, relative to where we were a couple of years ago, no big changes on the real growth front.
Where we have seen more of an evolution is on the inflation front. Obviously, we've been in a high inflation environment over the course of the last year or 18 months. We've seen those inflation expectations get jolted upward. What we don't think is that we're in a dramatically different environment relative to the pre-pandemic norms.
This is not a return to the 1970s. We think that policymakers and voters are telling us they really want moderate inflation, not high inflation. And we don't really think the economy is inherently much more inflationary than it was before.
And so, really what we're talking about now is, instead of missing inflation targets on the low side, central banks are now going to be able to hit those targets, and maybe there's a moderate overshoot over the course of the next couple of years.
So, more of a change on the inflation front and the growth front, but on both counts, this doesn't look like a dramatically different world than the one that we knew before.e
David Lebovitz: And I think that that's a key point because we get questions all the time about the productivity question, for example, or is inflation going to be a structural issue? And we all spend a lot of time, led by you, really unpacking those. And this is where we shook out.
So, not a lot of change on the inflation and the growth front, but obviously, a more significant change in terms of expected asset returns. And when we think about our dollar-denominated 60/40 portfolio return forecast, that number has risen from 4.3% last year to 7.2% this year, with that outlook being driven by an improvement in the view around both equities, as well as fixed income.
And so, since we're talking about macro, let's transition and talk a little bit about fixed income. First, what really drove this improvement in expected returns? And importantly, kind of in a similar vein to the question I just asked you about growth in inflation, have the views around equilibrium rates, or equilibrium spreads, been adjusted in light of everything that's gone on over the past couple of years?
Michael Hood: This is primarily about valuations. For the last several years now, we've been talking about how there was a big overhang of valuations on both fixed income and equities relative to what we thought reasonable long-term equilibria are. Those equilibria, in our assessment, haven't changed much.
And again, that comes back to the fact that we see only moderate adjustments to the economic outlook. So, the equilibrium assumptions for cash rates and bond yields have come up a little bit at the margin, but they're still within shouting distance of where they were before.
What's obviously changed is the starting point for yields, which went from being way below what we thought would be sustainable over the long term, to now in many cases, actually a little bit above those longer-term equilibria. So, that duration overhang, as if anything, from a return perspective, turned into a tailwind.
And so, you're talking about taking returns on the risk-free assets, those 10-year government bonds from, in many cases, very low or even negative numbers, up to numbers that are in the three, four, 5% range, which make some sense if you just think about where the starting yields are.
We know there's a strong connection between the yield you're buying fixed income at and the eventual return, and that's the part of the environment that's obviously changed sharply over the last year.
David Lebovitz: Excellent. So, maybe transitioning over and thinking a little bit about the equity side of the 60/40 portfolio, you kind of mentioned it in the context of fixed income. A lot of what has driven these changes is around the outlook and the current state for valuation. Have any other views on the equity front really changed all that much?
Again, you know, is this driven by valuation? Is it driven by something else? And I know one question that I've been getting quite a bit really has to do with the outlook for profit margins. So, maybe you could talk a little bit about, one, the valuation component, and then kind of broader, the outlook for equity returns going forward.
Michael Hood: Again, the starting point is really what matters here. We've cleared the decks on what was just as big a valuation overhang that we thought was in place on the equity side, as we did on the fixed income side. So, again, no big changes to where we think markets are going to be trending toward in terms of, let's say PE ratios over time.
We've already made some adjustments on that front, as you know, David, over the course of the last couple of years. We think that the US equity market can sustain a higher PE rate over the long term than has been the average in the past. And a lot of that's about sector composition.
We just got more tech names for example in the index today, and we think that's a sector that people have been willing to pay up for over time. But this year, we didn't do a lot on that front. And really, what happens in the numbers is, you're just taking a big drag from valuations and turning that into either a neutral factor, or again, in some cases, a tailwind, because we've flipped from being above those long-term equilibrium PEs, to now being either in line with, or in some cases, slightly below.
As you mentioned, there is an offset there for margins. So, again, one of the things that's happened over the course of the last couple of years is that US companies in particular, have just become much more profitable from a starting point that was already pretty elevated by historical standards.
And we do think that some of that will reverse. Some of that is a temporary post-pandemic phenomenon. And in particular, as we do see inflation slowing over the course of the next couple of years, we think that's where that margin squeeze is really going to come in.
Companies have benefited from being able to raise selling prices. And as that runs out of steam, those margins will contract. And so, that's a little bit of an offset to the valuation story, but it's really the huge change in valuations that takes us up from again, low to mid-single digits to, in many cases now, upper single digits and expected returns for public equities.
David Lebovitz: So, with all that said, we've talked about the US primarily. We focused in on the fact that valuation is driving a big part of the return, but also some expectation that maybe the equilibrium valuation, given the composition of the US market, may be a little bit higher over time.
That begs the question of, what are we expecting from non-US markets? You know, one of the things that you and I have discussed is that generally, the stack ranking has stayed the same in terms of on a relative basis, what we think will outperform. But what's the view on non-US markets? And specifically, how are we thinking about the dollar and the potential impact on the currency on forward returns?
Michael Hood: It's really the dollar that's going to play the crucial role there. We don't see a lot to choose from in terms of local currency returns between US and international. Obviously, the US has outperformed everything else on the planet over the course of the last 10 years.
We think some of that was coming from really relatively cheap valuations to now valuations that are higher relative to long-term equilibria than maybe is the case in some other places, or let's say other markets look cheaper relative to those long-term norms that we're shooting for than is the case for the S&P. But ultimately, a little bit more revenue in the US, maybe a little bit cheaper outside the US, kind of shakes out to being broadly in line in local currency terms. But the one valuation out there that's really not corrected at all over the course of the last year, is the dollar.
The dollar's actually gotten squeezed higher by relative growth stories, and in particular, by a more aggressive central bank in the US that's favored the carry. And so, we've been talking for a while now a few years about the dollar being expensive relative to a long-term history, and that's just gotten exacerbated over the course of the last year.
We don't really have any sense of when that's going to reverse. Although we point out that in recent weeks, we have seen some signs that dollar strength might be turning. And again, we'd associate that with that change in the relative central bank environment, which we think will be characteristic of the long-term.
But again, don't want to extrapolate that trend into thinking about when exactly the dollar's going to come down, but we do think that there's plenty of room for the dollar to depreciate against most of the other developed currencies in particular over the long-term, and we do think that'll be a tailwind for international assets.
And so, we do think it makes sense to maintain that diversifying exposure to non-US equities in part to hopefully catch that eventual support from a weaker dollar.
David Lebovitz: Yes. And certainly, a thesis that we've been talking about for some time. I agree with you, a couple of data points don't necessarily constitute a trend, but hopefully, we begin to see the dollar put itself in reverse over the course of the medium term.
So, today, we focused on the macroeconomic side of things. We've focused on public markets, equities, fixed income, US, non-US, so on and so forth. Over the past couple of years, more broadly, particularly when expectations for the 60/40 portfolio return were relatively modest, we spent a lot of time talking about alternatives.
We wrote articles about how alternatives were transitioning from optional to essential. We added a venture capital forecast for the LTCMAs this year. Would love to get your view on the role that alternatives will play in portfolios going forward in terms of diversification and helping to moderate risk, but also enhancing return, because one of the things we did see in the alts assumptions is that the story is very different for the financial alternatives, as opposed to the things like core real assets.
So, can you talk a little bit about where the returns shook out in the aftermath of this year's exercise, and how you think about alternatives from a portfolio construction aspect in a world where public markets are expected to deliver more than historically was the view?
Michael Hood: Still a crucial tool for building portfolios, we think, probably in a little bit more balanced way than we've been talking about in the last years, where, as you mentioned, public equity and fixed income returns were so low that in order to get anywhere close to a desired or needed return target, you really had to push out far into taking that illiquidity and complexity and manager due diligence and dispersion risk, just because that's where the returns were.
We think that now alts can go back to playing a sort of more appropriate role in portfolios, where again, they're providing significant alpha on the financial alts side, again, assuming that you're getting top-quartile returns among the managers. But we do think that there is alpha to be had in both private equity and hedge funds relative to the corresponding market betas.
And so, private equity is still going to stand out as one of the highest-returning asset classes in our group, and hedge funds offer reasonable returns in between fixed income and equities for relatively low volatility. On the real asset side, we think there, the appeal is, again, a little bit of diversification, because you're getting a slightly different set of economic exposures than you have available in the public markets, whether that's real estate or infrastructure or transport, things like that.
But it's also the case that these asset classes probably have more embedded inflation protection than you're going to get in the public markets. And again, we're not telling a really high inflation story. We don't think this is something where you need to turn the portfolio upside down about, but it makes sense to hedge that as a risk, and the real alts are probably the best tool that we have for doing that.
Those return expectations haven't changed much over the course of the last year, in part because those were the asset classes that we thought were relatively cheap compared with public equities, for example, and those valuations haven't really adjusted. So, there's an increase in expected returns for the financial alts because of the embedded public market beta.
Pretty similar returns to last year on the real alts side, and therefore slightly different roles that each of them should be playing in a portfolio.
David Lebovitz: What's interesting is in the past, we've used AID, Alpha Diversification and Income, to talk about alternatives. I think that AID still applies, but it's more about alpha inflation protection and diversification, given the outlook from here. And so, this has been a fantastic conversation.
I wanted to ask you one question just to kind of wrap things up here, and this is something that we talked about throughout the LTCMA process, but we're now in a world of higher interest rates, and we're also in a world where capital is going to increasingly be in demand.
And so, how do you think about the role of financial markets in allocating this capital and the issue of capital scarcity as we look ahead over the course of the next 10 to 15 years?
Michael Hood: It's probably created some alpha opportunities in areas like the energy transition, for example, where there's going to be a need for investment and money's not free anymore, and somebody's going to have to provide that capital, and that's going to come at a cost.
And so, lending into those areas looks a lot more appealing perhaps than it did a year or two ago. It's also the case that the cash rate has come up, right? I mean, that's the point you're making about money not being free. And that, I think just creates a higher bar for all of the risk-taking that you're doing in a portfolio and for investment projects as people evaluate them.
So, I think there's likely to be more winners and losers over the course of the next years in that environment, which is just enforcing or imposing more discipline on both borrowers and lenders than has been the case for the last years.
And that has some downside, but also does feel nice to be back in a more normal environment where interest rates are not negative and where you've got kind of an appropriate stack of returns across the spectrum.
David Lebovitz: And dare I say, perhaps an environment of winners and losers is better for active managers, but time will certainly answer that question for us. So, Michael, as always, great to have you join us on the podcast. Thank you so much for your time today, and looking forward to having you back again soon.
Michael Hood: Thanks for having me.
David Lebovitz: Thank you for joining us today on JPMorgan Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our website. Thank you. Recorded on November 14th, 2022.
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