Q&A on Our Capital Market Projections

Callan recently published our 2018 Capital Market Projections, detailing our expectations for return, volatility, and correlation for broad asset classes. These projections represent our best thinking regarding a longer-term outlook and are critical for strategic planning as our investor clients set investment expectations over five-year, ten-year, and longer time horizons.

(Estimated reading time: 3 min 10 sec)

  • Over the next 10 years, we forecast annual GDP growth of 2% to 2.5% for the U.S., 1.5% to 2% for non-U.S. developed markets, and 4% to 5% for emerging markets.
  • For broad U.S. equity, we project an annualized return of 6.85% with a standard deviation (or risk) of 18.25%; for global ex-U.S. equity a return of 7.00% (risk: 21.00%).
  • For broad U.S. fixed income we project a return of 3.00% (risk: 3.75%).

In the following Q&A, we outline our high-level thinking about the projections and the capital markets.

Q: What should clients be focused on when evaluating their current asset allocation?

A: Understand your risk tolerance and liquidity characteristics when deciding on the appropriate asset allocation. Investment policy choice must be driven by plan-specific considerations. Remember that expected return is an output rather than an input of the strategic asset allocation process!

Q: What are the biggest risks you see in the capital markets?

A: We see three:

  1. Investor behavior that persistently overweights U.S. equities even after their substantial run-up compared to other equity markets around the world.
  2. Presuming that the stock/bond correlation will stay zero or negative indefinitely. In inflationary episodes, stocks and bonds can draw down materially at the same time. As cash yields continue to grow more attractive over time, it may be increasingly appropriate to view cash as the true “risk-free” asset given its lack of duration risk.
  3. Another potential risk is linked to the rapid growth of algorithmic trading strategies. Once solely the domain of professional investors, algorithmic strategies are being widely adopted in the retail market. One example is short volatility, where retail investors are essentially writing insurance to protect against equity drawdowns. Given the uncertainty of human behavior, the broad uptake of algorithmic strategies could be destabilizing in a situation where investors seek to unwind their positions at the same time.

Q: What are the biggest risks you see with client/investor behavior?

A: We see investors (including large institutional bellwethers) continue to pile into or remain committed to large allocations to growth assets to try to reach aggressive return on asset targets. In their concern “not to miss out,” they are potentially exposing themselves to excessive downside.

Q: How has investment time horizon changed as it relates to generating capital market expectations?

A: In the late 20th century, capital market assumptions used for strategic planning purposes were often thought to be “equilibrium” forecasts with a very long (multi-decade) time horizon. These “equilibrium” assumptions were generally formed by assuming invariant risk premia between asset classes and were often calibrated from historical relationships.

The Tech Bubble and the Global Financial Crisis both highlighted that markets can diverge dramatically from “equilibrium.” As a result, practitioners have more recently migrated to approaches that place greater emphasis on using explicit forward-looking economic and market forecasts as inputs into capital market projections.

Today, consultants tend to use 10-year projection horizons, given their emphasis on strategic planning, whereas investment manager projections tend to be more short-term oriented, given their intent is often to inform tactical deviations from a home policy position. We have also seen shorter time horizons used to emphasize market risks (5-7 years), as well as extensions to 15-year time horizons (or longer) to justify higher return expectations for those who consider themselves to be “truly long-term” investors.

Q: How did the projections change from those made in 2017?

A: The intent of Callan’s Capital Market Projections is long-term strategic planning. We have gradually ratcheted down our expectations over recent years to reflect a lower growth environment with lower expected returns. However, we only change our forecasts when we believe asset class prospects have materially changed.

After careful consideration and considerable analysis, we chose to retain our capital market projections from 2017, with no changes. We believe the rationale for our long-term projections set a year ago; we confirm our belief that a 10-year S&P 500 equity forecast of 4.5% in annualized real terms is solid. This forecast is somewhat lower than the index’s longer-horizon performance and reflects more subdued prospects for U.S. economic growth relative to history.