Callan develops long-term capital markets assumptions at the start of each year, detailing our expectations for return, volatility, and correlation for broad asset classes. These projections represent our best thinking about the outlook for equities, fixed income, real assets, and alternatives, and they are a critical component of the strategic planning process for our institutional investor clients as they set investment expectations over five-year, ten-year, and longer time horizons.
Our assumptions are informed by current market conditions but are not directly built from them since the forecasts are long term in nature. Equilibrium relationships between markets and trends in global growth over the long term are the key drivers, resulting in a set of assumptions that typically changes slowly (or not at all) from year to year. Our process is designed to ensure that the forecasts behave reasonably and predictably when used as a set in an optimization or simulation environment.
Our process begins with estimates of major global macroeconomic variables, which are integrated into our equity, fixed income, and alternative investment models to generate initial forecasts. We then make qualitative adjustments to create a reasonable and consistent set of projections. In years past, we have made evolutionary, rather than revolutionary, changes to our assumptions. As part of the process, we ask the question: What do we know now that is substantially different from what we knew a year ago that would cause us to change either our expectations or our resulting asset allocation advice?
Of course, 2020 turned out to be a truly historic year.
For the period 2021-2030, we made almost revolutionary changes to our capital markets assumptions. We reset fixed income to reflect the much lower yield environment going forward, and we revisited the relationship between asset classes in this new world order. We examined the equity risk premium in light of the new fixed income expectations as well as the high valuation levels that have resulted from the incredible market recovery since April 2020. Fed policy pivoted dramatically following the onset of the pandemic and the imposition of shelter-in-place orders around the globe. Interest rates are now reset to a much lower level after the Fed pivot, and we expect rates to rise more modestly over the next five years.
As a result of our rigorous process, we have lowered our fixed income assumptions to reflect lower starting yields compared to one year ago, including a lower return for cash. We lowered our equity return assumption to reflect concerns about valuation, but we widened our equity return premium over cash and the equity risk premium over bonds.
We always argue that we only adjust our forecasts when we believe asset class prospects have materially changed; we believe 2021 is one of those times.
U.S. Equity: We anticipate a strong rebound in earnings in 2021 followed by sustained growth that is expected to be modestly above GDP growth given the low level of initial earnings. Our projected return for the S&P 500 reflects a 25 bps drag due to high valuations. As price appreciation slows and pandemic fears ebb, we anticipate the dividend yield for the S&P 500 to rebound to 2%.
Inflation plays a role in equity forecasts since the variables described above are forecast in real terms with inflation added to generate nominal returns. Our forecast for inflation has fallen 25 bps, which translates directly to a 25 bps decline in our nominal equity return forecast.
Global ex-U.S. Equity: Many of the same factors limiting our U.S. equity forecasts have also reduced our projections for global ex-U.S. equity. COVID-19 weighed heavily on 2020 developed market earnings. Once earnings have recovered, growth is likely to track only marginally ahead of GDP gains, which we expect to be 1.75% on average over the next 10 years. We expect dividend yields, which have been suppressed by the pandemic, to rebound to 3% on average over the next 10 years. A 25 bps decline in anticipated inflation further reduces the nominal return forecast.
Emerging market earnings are expected to be about double those of developed markets. Expected inflation is higher than in developed markets but is expected to fall below historical levels, resulting in lower nominal returns.
Fixed Income Forecasts
Core U.S. Fixed Income: The primary driver of our lower expected return forecasts for 2021-2030 is lower starting yields. The yield of the Bloomberg Barclays US Aggregate Bond Index decreased significantly for the second consecutive year, reaching an all-time low of 1.02% on August 4. As a result of the pandemic, the Treasury yield curve is low on an absolute basis, but the slope is steeper than it has been in recent years. We expect rates to rise incrementally and steepen further over the next 10 years, with the long end of the curve rising more than the short end given the Fed’s influence on the short end.
Historically low starting yields provide minimal carry and narrowly offset capital losses in the early years of our forecast; capital losses are incurred as rates slowly rise to a higher equilibrium. Higher yields in later years will enable higher fixed income returns since yields are the most important driver of bond performance.
Projected upward-sloping yield curves in the forecast provide a return tailwind, resulting in positive roll returns as bond issues gradually move toward maturity. Roll returns are expected to more than offset any anticipated losses from downgrades and defaults.
Alternative investments differ substantially from each other, so we use different models for each.
Hedge Funds: Callan’s 10-year cash forecast is 1.00%, which is the starting point for our hedge fund returns. Diversified hedge fund portfolios have historically exhibited equity beta relative to the S&P 500 on the order of 0.4. Combined with our equity risk premium forecast, this results in an excess return from equity beta of just over 2%. Return from hedge fund exotic beta and illiquidity premia is forecast to be 0.5% to 1.0%, to arrive at an overall expected return of 4.0%.
Private Real Estate: The low interest rate environment for the foreseeable future should help to ensure that real estate continues to garner interest from investors seeking income, supporting returns. However, the momentum in the Industrial sector is more than offset by the headwinds faced by Retail and Office, which should prove to be a drag on performance. The combination results in a 50 bps reduction in our outlook for real estate returns compared to last year.
After adjusting for the embedded leverage in core real estate, we forecast the expected real estate return to be about 85% of the excess return (versus cash) of the U.S. equity market. When combined with the forecast cash return, this calculation results in a projection of 5.75%.
The real estate risk forecast reflects economic realities rather than observed volatility. Observed volatility is often less than 5%; however forecasting, for example, a 3% standard deviation implies that the real estate loss experienced during the GFC was a 10+ standard deviation event. Our forecast for risk better represents the probability of a loss of this magnitude.
Private Equity: The private equity market in aggregate is driven by many of the same economic factors as public equity markets. Consequently, the private equity performance expectations declined 50 basis points relative to where they were last year.
Return and risk reflect the leverage being employed in funds that target the asset class. We see tremendous disparity between the best- and worst-performing private equity managers. The ability to select skillful managers could result in realized returns significantly greater than projected here.
As is the case with real estate, the projection for standard deviation for private equity is consistent with risk of loss rather than a measure of observed volatility. Our forecast for private equity risk approximates the ratio of return to risk for the other equity asset classes we forecast.
Private Credit: Private credit was added to Callan’s capital markets assumptions this year. Return and risk reflect the leverage being employed in funds that target the asset class. Yields on loans to middle-market companies have a persistent premium to yields on loans to large corporations, which helps to support an assumed return premium. As is the case with other alternatives, the projection for standard deviation for private credit is consistent with risk of loss rather than a measure of observed volatility.