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Wealth Management
Capital Market Assumptions 2021

2021 Capital Market Assumptions

In this 2021 installment of Capital Market Assumptions, CAPTRUST’s investment team provides economic and market insights over a time horizon of 10 years or longer. Read on for their expectations for economic factors such as gross domestic product and inflation, as well as return and risk expectations for stocks, bonds, and other asset classes.

As investments are inherently forward-looking, CAPTRUST formulates and revises capital market assumptions on a regular basis. Capital market assumptions provide a foundation for formulating a long-term, strategic asset allocation and can aid as inputs in developing long-term portfolio allocations and investment policies. These assumptions encompass economic factors such as gross domestic product (GDP) and inflation, as well as publicly traded stocks and bonds and private investments. These capital market assumptions are intended to reflect a long-term time horizon of 10 years or longer.

As such, they are not intended to be short-term or tactical in nature or prescriptive for any individual year. These assumptions are not explicitly designed to be an input for any specific accounting or actuarial calculations. While some of the assumptions have changed since last year, the lowering or increasing of an assumption does not indicate a higher or lower return assumption over a short-term time horizon.

As asset allocation has been shown to be the primary driver of long-term investment performance, these expectations are likely to play a key role in long-term investment outcomes. It should be noted that as the future is uncertain, these assumptions should be availed with the understanding that they are only our best approximation with the current information that is available.

U.S. Economy. Expected real GDP growth has been adjusted upward from 0.5 percent to 2.2 percent, the result of the U.S. economy pivoting quickly from a recession that began in March 2020 to an environment of strong expected economic growth for the next few years with a resumption of trend (slower) GDP growth thereafter. Inflation expectations have also been adjusted higher from 1.75 percent to 2.3 percent.

Equity Markets. A sustained economic recovery has propelled corporate earnings expectations strongly higher, which has been accompanied by substantially higher equity valuations. Given that much of the recovery is now priced into current equity prices, our return assumptions for equities remain mostly unchanged for 2021 as these two factors offset each other. While the market environment appears favorable for equity investors, valuations (as measured by forward price-to-earnings ratios) are currently on the higher side relative to history.

Our assumptions for foreign developed equities have been lowered by 0.25 percent given the secular growth challenges, and our return expectations remain below that of U.S. equities. Our return assumptions for emerging market equities remain the same and are still slightly higher than developed equities, albeit with higher expected risk.

Fixed Income. Interest rates are currently low by historical standards, and this is exerting downward pressure on return expectations for fixed income. Our expected return for core fixed income is 2 percent, down slightly from 2.1 percent in 2020. Our views reflect a base case assumption that interest rates will gradually rise, and the interest rate yield curve flattens, with the longer end of the yield curve being less impacted by higher rates.

Real Assets. Higher valuations relative to history (as measured by real estate capitalization rates) have caused us to maintain or slightly reduce our assumptions for future returns for public and private real estate, commodities, and core private real assets.

Other Alternatives. Private equity should continue to provide a premium to public equity markets, with the downside being less liquidity and transparency. We expect this return premium to average 2 to 3 percent above public equities. Core private credit and hedged strategies may provide diversification benefits for certain equity and fixed income investors. Given that credit spreads are now at or near historic lows, we have maintained or slightly pared back our return assumptions for alternatives in 2021.

U.S. Economy

Gross Domestic Product

The U.S. economy is experiencing a strong rebound as we enter the second half of 2021. Fiscal and monetary stimulus and an unleashing of pent-up demand should drive robust GDP growth for several years before eventually returning to a slower 1.5 percent growth trend. Our expectation for the next 10 years is GDP growth of 2.2 percent, with much of that growth coming over the next several years as consumer demand and accommodative monetary and fiscal policies stoke economic expansion. For the actual yearly figures, we relied on research produced by Oxford Economics (as shown in Figure One).

Figure One: Expectations for Real GDP Growth

Source: Oxford Economics

Inflation

We expect that inflation will run above trend as a byproduct of the economic expansion and accommodative policies. As with GDP, we expect above-average inflation in the near term before it settles back down to near 2 percent over time. Our assumption for inflation over the next 10 years is 2.3 percent, which is slightly above the 2 percent inflation targets of the Federal Reserve and very close to the market-observed 10-year inflation break-even rate of 2.34 percent (obtained via Bloomberg) as of June 30, 2021. Additionally, we utilized research from Oxford Economics shown in Figure Two below.

Figure Two: Expectations for U.S. Inflation Rates

Source: Oxford Economics

Public Equity Markets

Dividend and Earnings Discount Model

This model utilizes a version of the Gordon discount model for establishing baseline return expectations for equity markets and was aided by models produced by Cliffwater’s 2021 Asset Allocation Report. Our approach is to formulate equity return assumptions for the S&P 500 Index that can then be used as a foundational reference point for other global equity asset classes. The model assumes that the S&P 500 Index long-term dividend payout (including repurchases) from an earnings rate of approximately 45 percent will continue in the future.

Since 1953, the S&P 500 Index earnings growth rate has been 5.6 percent. As of June 30, 2021, the S&P 500 Index was valued at 4,298, and the forward expected earnings per share (EPS) was $189. We used a slightly lower future nominal earnings growth expectation of 5.3 percent.

The required rate of return inferred from the Gordon discount model comes to 7.3 percent. This is somewhat below the average inferred rate of return of 8.3 percent from 1990 to 2021. The actual investment return for the S&P 500 Total Return Index over this same time period (from January 1, 1990, to June 30, 2021) was 10.5 percent, but the forward earning price-to-earnings ratio multiple also expanded from around 13 times earnings to around 22 times earnings over this time frame and remains elevated relative to history.

Our observation is that for equity returns to be much higher than the 7.3 percent inferred rate of return of over the next decade, either earnings would need to grow at an above-average rate or price-to-earnings multiples would need to expand far above what the U.S. equity market has ever sustained.

Figure Three: Equity Earnings Metrics

While the model and chart below is not precise, Figure Four does give an indication of whether the expectations for the longer-term forward returns are below or above average. For example, in 2000, market valuations were high, and the S&P 500 Index experienced lower return for the next 10 years. In 1990 and 2011, valuations were low, and the S&P 500 Index returns over the next 10 years were above average. Currently, the model would indicate that we should expect below-average future returns.

Figure Four: S&P 500 Index—Inferred Forward Required Rate of Return

Source: CAPTRUST Research

Historical ERP Approach

The historical premium approach estimates the equity risk premium (ERP), where the actual returns earned on stocks over a long period is estimated and compared to the actual returns earned on a default-free (usually government-issued) security. The difference, on an annual basis, between the two returns represents the historical risk premium.

Conceptually, the ERP is the compensation investors require to make them indifferent at the margin between holding a risky market portfolio and a risk-free bond. Because this compensation depends on the future performance of stocks, the ERP incorporates expectations of future stock market returns, which are not directly observable.

How much have investors been compensated over time for owning U.S. stocks versus intermediate-term U.S. Treasurys? Utilizing the Stocks, Bonds, Bills, and Inflation (SBBI) Ibbotson Database to compare the returns of the U.S. Large-Cap Stock Total Return Index to the U.S. Intermediate-Term Government Bond total return, the return difference from 1926 to 2020 shows an ERP of 6.9 percent arithmetic average and a 5.2 percent geometric average. Between 1970 and 2020, the arithmetic and geometric averages are calculated as 4.9 percent and 3.7 percent, respectively, demonstrating that the equity risk premium may have declined over time.

According to Figure Five, research compiled by Aswath Damodaran at the Stern School of Business at New York University shows the implied equity risk premium from 1960 to 2020 to be 4.2 percent.

Figure Five: Implied Premium for U.S. Equity Market (1960 to 2020)

Source: Stern.nyu.edu

In summary, if we put together our expected return on the U.S. 10-Year Treasury of 1.8 percent and add a risk premium of between 4 and 5 percent, that results in an expected nominal return range for U.S. large-cap stocks of between 5.8 percent to 6.8 percent.

Peer Comparisons

Analysis was conducted on industry peers who also formulate capital market assumptions. Of the 19 peers researched, the average forward expectation for U.S. large-cap stocks ranged from 1.7 to 7.7 percent, with the average being 5.6 percent.

Valuation Considerations

As of June 30, 2021, the S&P 500 Index traded at a forward price-to-earnings ratio of 22.3, while the previous 25-year average was 17.3, per Bloomberg. This metric would indicate that the market is 29 percent overvalued relative to its 25-year average. While the argument could be made that stocks are still cheap relative to bonds, stocks do appear expensive relative to their own history when considering the current forward price-to-earnings ratio. Incorporating this information into our forward return expectations would indicate future returns that are lower than historical returns which have averaged approximately 10 percent.

U.S. Equity Market

Considering the above research, we have maintained our return assumptions for U.S. large-cap equities at 7.25 percent. We expect strong economic growth to persist for the next two years and then resume a slower growth trajectory after that. The economy has recovered rapidly from the sharp slowdown experienced in 2020, and corporate profitability and earnings growth remain quite robust. However, equity valuations remain high on a relative basis, which we expect will be a headwind for equities over the next 10 years.

U.S. Mid- and Small-Cap Equity

As shown in Figure Six, from the end of 1990 to June 30, 2021, mid-cap and small-cap equities have outperformed the S&P 500 by a small margin of 1.6 percent and 0.3 percent, respectively. Over the past several years, large-cap stocks have outperformed both mid- and small-cap stocks. Over the long run, we continue to expect mid-cap and small-cap equities to exhibit a small return premium to large-cap stocks while exhibiting higher volatility. We have maintained our assumption for mid-cap and small-cap equities at 7.5 percent.

Figure Six: Mid- and Small-Cap Equities Outperformed the S&P 500 Index (1990–2021)

Source: Bloomberg

International Equity Markets

Over the past 30 years, U.S. markets have outperformed international developed and emerging market equities. From 1990 to 2020, U.S. large cap stocks returned 10.7 percent, compared to 6.1 percent and 9.4 percent for international developed and emerging market equities, respectively. International equities continue to trade at a discount to U.S. equities, which makes them relatively attractive from a valuation standpoint, but they have historically traded at a discount to U.S. stocks and may continue to do so going forward. Emerging market stocks have exhibited significantly higher volatility compared to developed equity markets.

We slightly lowered our return assumptions for international developed stocks and maintained our return assumption for emerging market stocks. Global economic conditions appear favorable for sustained earnings growth throughout these regions, but, as with U.S. equities, valuations are substantially higher than in May 2020. We continue to expect that international developed market economies will have structural and demographic disadvantages to the U.S. that will continue to be a secular economic headwind.

Emerging market economies are experiencing faster economic growth than both U.S. and other developed economies, and they may benefit if the U.S. dollar weakens compared to local currencies. Valuations also appear attractive within emerging market stocks. However, these economies are not as insulated from global economic shocks when compared to developed economies, and we would expect continued higher volatility within emerging markets.

We expect developed international equities to underperform U.S. equities by 0.50 percent and emerging market equities to outperform U.S. equities by 0.50 percent. We continue to believe both international developed and emerging market equities can provide diversification benefits to an overall equity portfolio.

Fixed Income

Core Fixed Income

Forward returns are highly correlated to the current level of yield. However, shorter-duration fixed income assets may have an advantage over longer-duration fixed income assets if interest rates rise moderately over the next 10 years, as these shorter-duration investors can then reinvest at higher rates. Therefore, our expectation is that returns for shorter-duration fixed income holdings will have a total return a bit higher than their current yield. However, we also expect that as interest rates rise, the interest rate yield curve will flatten, and, therefore, intermediate, and longer-term rates should rise less than shorter-term rates.

Our expectation is that short-term interest rates will gradually rise to slightly above 2 percent over the next five years and remain near that level. We base this expectation on current Fed Funds futures going out over the next 10 years, as shown in Figure Seven below.

Figure Seven: Implied Fed Funds Rate

Source: Cornerstone Macro

This allows us to incorporate a cash flow and spread premium analysis on various fixed income asset classes. An upward interest rate move will reduce the valuations for longer-duration assets and put a damper on total returns until investors are able to realize the benefits of higher coupon payments. We expect U.S. core fixed income to have a return of 2 percent, down slightly from 2.1 percent in 2020.

U.S. Treasury Bonds

Our expectation for U.S. Treasury bills is 1.6 percent and 1.7 percent and 1.9 percent for intermediate- and long-term U.S. Treasury bonds, respectively. Treasury bills should eventually benefit from higher interest rates; however, returns for T-bills will remain low until interest rates go higher. We expect that longer-duration bonds will be temporarily discounted if rates rise quickly, but over the longer run, they should benefit from higher coupon payments and a flattening of the yield curve, which may shield longer-duration bonds from drastic downward principal repricing that could happen with a textbook parallel yield curve shift.

Our expectation for Treasury Inflation-Protected bonds (TIPS) remains at 2 percent. The return outcome of TIPS is likely to be impacted by the magnitude of the difference between future expected inflation and realized inflation.

Global Bonds

Fixed income yields remain low to negative throughout much of the developed world. Thus, return expectations remain low for global fixed income. Our expectation for global fixed income is 1.5 percent. However, U.S. investors may experience some additional return benefits from favorable currency hedging differentials. While many domestic investment funds that invest in foreign bonds hedge their currency risk, there may be additional volatility from currency fluctuations in strategies that are not hedged to the U.S. dollar.

Credit and Corporate Bonds

Investment grade credit markets have recovered completely from the corporate bond market selloff that occurred in the first half of 2020. Option-adjusted spreads (as seen in the chart from the Federal Reserve of St. Louis) are tighter than in any time over the last five years and stand at only 0.86 percent above U.S. Treasury bonds (as of June 30, 2021). Longer-duration corporate bonds are also at risk from rising interest rates that could significantly discount their value if rates were to rise meaningfully. Expectations for net credit losses must also be factored in. We are reducing our return expectation for U.S. corporate investment grade bonds from 3.1 percent to 2.3 percent, and from 3.85 percent to 3.1 percent for longer-duration corporate bonds. Our expectation for U.S. credit is also 2.3 percent.

Figure Eight: U.S. Corporate Bond Index Option-Adjusted Spread

Source: Federal Reserve of St. Louis

High Yield Bonds

Below-investment-grade credit markets benefited greatly from central bank intervention and the massive liquidity injected into the economy to keep it afloat. As a result, high yield bonds have performed well lately. However, as seen in Figure Nine, high yield bond yields and option-adjusted spreads are quite low by historical standards. We expect lower returns going forward. Our forward expectation for high yield bonds is 3.1 percent, which also factors in an estimate for expected net credit losses.

Figure Nine: High Yield Bond Index Yield to Worst

Sources: Bloomberg, CAPTRUST Research

Floating Rate Bonds

Floating rate bonds can be expected to perform well in periods of rising rates due to their low-duration features. However, they can also experience credit losses and have been more volatile than core fixed income. We expect floating rate fixed income to return 3.1 percent after factoring in expected net credit losses.

Municipal Bonds

Local governments have not seen the precipitous drop in tax revenues that were originally projected by some at the onset of the COVID-19-related lockdowns. Municipal bonds have also performed well in recent times, helped in part by the demand for tax-exempt income from investors. The prospect of higher future tax rates should continue to be an advantage for this asset class. However, like other fixed income asset classes, yields are very low relative to history, with the current yield on investment grade municipal bonds near 1 percent.

Our expectation is that rates will eventually rise over the next three to five years and that municipal bond investors may eventually benefit from moderately higher coupon payments. While current yield to worst (YTW) is near 1 percent, research shows that investors often end up earning a return a bit higher than what can be expected from YTW. This is likely due to the observation that issuers of municipal bonds often do not always precisely exercise the call provisions that would allow them to reissue bonds at lower rates, even after these issuers have the option to call in the higher yielding bonds and reissue new bonds at lower rates. Our longer-term expectation for municipal bonds is 1.9 percent.

Real Assets

Real Estate

We develop expectations for both U.S. public real estate investment trusts (REITs) based on the Dow Jones U.S. Select REIT Index and U.S. core private real estate based on the NCREIF Property Index. Public REITs have historically experienced equity-like returns and volatility that is in line with or higher than public equities. Public REITs have also demonstrated a much higher correlation to U.S. public equities than private real estate.

However, private real estate pricing will often exhibit a pricing lag, as valuations are generally conducted via an appraisal method, as compared to public REITs, which are traded on open exchanges. Private real estate returns are likely more correlated to U.S. equity markets and have higher volatility than the available data shows.

Public REITs pay most of their taxable income as dividends, and their historical dividend payouts fluctuate less than public equities. Since a large portion of profits are paid out as dividends, earnings growth can be estimated to be in line with inflation. We would therefore expect the return for public REITs to be the sum of the approximate dividend yield of 3.2 percent and inflation of 2.3 percent, which is 5.5 percent.

Over longer periods of time, public and private real estate returns have been relatively close. We would expect that, while private real estate may benefit from a small illiquidity premium, public real estate will utilize higher leverage that can give it a return advantage over private real estate. We would expect the return for private real estate to also be similar to public REITs, albeit with lower volatility and less correlation to public equity markets.

Returns for public and private core real estate have been around 4 percent higher than core fixed income over the past 25 years. Our forward expectation for core fixed income is 2 percent. Adding these together would result in a forward expectation of 6 percent for public and private real estate.

Using a combination of these methods, our return expectation for both public and private core real state is 5.75 percent.

Commodities

Over the past several decades, commodities have been volatile, and returns have been low as measured by the Bloomberg Commodity Index. Over the past 30 years or so, this index has returned just over 2 percent, with a standard deviation of more than 14 percent and a slightly negative Sharpe Ratio, indicating that, in absolute terms, investors have not been compensated for the risk inherent in commodities.

Commodities tend to perform strongly during times of higher inflation but then produce low or negative returns when inflation is lower. One challenge with investing in commodities is the difficulty for investors to invest directly in a broad commodity basket. A more realistic method of achieving broad commodity exposure is by investing in commodity futures. However, as investors roll forward their commodity futures contracts during a periods of normal upward-sloping curves, they experience a negative roll yield that can be a drag on long-term performance.

Our expectation over the long term is that commodities will continue to appreciate in line with inflation as they have for the last several decades, while providing potential diversification benefits to equity and fixed income investors and having the potential for performing strongly during periods of higher inflation.

Core Private Real Assets

Investments in infrastructure are often secured by hard asset cash flows, exhibit a long-duration profile, and tend to prioritize stability of income over future growth. Infrastructure can include investments in transportation, energy, utilities, water, farmland, timberland, communications, and social (e.g., hospitals and schools) assets. Investments can occur through both public and private vehicles, with tradeoffs in liquidity, transparency, and volatility. Equity and fixed income investors alike may benefit from the diversification potential of complementing their portfolios with an allocation to real assets. Our return expectation remains at 5 percent.

Other Alternatives

Core Private Equity

Investors expect a premium return over public equities in exchange for loss of liquidity, less transparency, and more complexity. Research published by Cliffwater Research analyzed private equity returns from 2001 to 2020 and revealed a core private equity premium of 3.8 percent over public equity over this 20-year timeframe. Given the current environment, which includes widespread investor interest in private equity and the abundant availability of capital, we are estimating that core private equity will have a somewhat more conservative 2.5 percent return premium over U.S. large-cap equities, resulting in a return expectation of 9.75 percent.

Hedged Strategies

As hedge fund strategies seek to generate positive risk-adjusted returns that are not primarily driven by exposure to traditional long-only equity and fixed income investments, we would expect hedge fund strategies to generate alpha from taking advantage of exploitable market inefficiencies and tactical positioning. However, some of the return is also related to exposure to traditional sources of returns, such as equity beta and credit.

Data for hedge fund strategy returns demonstrate that alpha premiums for hedged strategies come to just under 4 percent going back 27 years.[1] We would expect that this alpha premium may be slowly diminished going forward as the number of participants competing for market alpha increases. Adding alpha of 1.5 percent plus 1.6 percent for U.S. T-bills plus 1 percent for beta exposure results in an expected return for hedged strategies of approximately 4 percent.

Core Private Credit

Our assumption for core private credit, which is based on the Cliffwater Direct Lending Index, is a return of 6.5 percent with a volatility profile similar to high yield fixed income. According to a recent report, “Private debt is a rapidly growing asset class among institutional investors, a trend that is expected to continue.” The report also notes that directly originated loans to middle-market companies are now a $139 billion market.[2] While total returns and higher current income have been an attractive feature of this asset class, we remain both constructive and cautious within the private debt market.

High yield bond spreads are indicating that investors are currently less concerned about embedded risks and may be more open to less stringent underwriting standards in the search for yield. If economic growth were to slow or stall, core private credit would likely see a reduction in fair value and perhaps even experience net credit losses. Incorporating these additional risks, we have reduced our return assumption for core private credit by 0.5 percent.


[1] 2021 Asset Allocation Report, Cliffwater, 2021

[2] Ibid