2024 Q3 Capital Market Assumptions
Overview
The US Federal Reserve (Fed) has acknowledged modest progress toward bringing inflation back to target but remained in wait-and-see mode. While the Fed left policy rates unchanged throughout the summer, the Summary of Economic Projections (SEP) suggested the Fed will cut rates only once in 2024, compared to expectations of three rate cuts earlier this year. Meanwhile, falling inflation has provided room for a number of other developed market central banks to cut rates in response to weak economic activity. Against this backdrop the Multi-Asset team’s Q3 2024 forecast includes:
- An annualized nominal 10-year return for Global Equities of 6.9%, a decrease from the forecast of 7.0% for the second quarter of 2024. The small forecast decrease is primarily attributable to less favorable valuations following a 3.0% advance in Global Equities in the second quarter of 2024.
- Global sovereign interest rates moved modestly higher in the second quarter as expectations for global central bank rate cuts were pushed further out into 2024 amid a still-growing global economy and inflation that generally remained above central bank targets. The long-run forecast for hedged Global Aggregate Bonds is 4.5%, an increase of 0.5% from last quarter’s forecast.
- The team’s forecast return for a balanced portfolio of 60% Global Equities unhedged and 40% Global Aggregate Bonds hedged is 6.3% annually over the next 10 years, an increase of 0.1% from the forecast for the second quarter of 2024.
Note: Forecasts may not be achieved and are not a guarantee or reliable indicator of future results
Summary
Q2 2024 Developments Informing Our Long-Term (10-Year) Forecasts:
The timing of central bank rate cuts loomed large in Q2 with a particular focus on the US Federal Reserve (Fed). Prior to the Fed’s June meeting, several participants highlighted concerns that inflation was sticky and slow to return to target. While the Fed ultimately left policy rates unchanged at that meeting (and at the July meeting as well), these concerns prompted an update to the Fed’s guidance. The Summary of Economic Projections (SEP) suggested the Fed will cut rates only once in 2024, compared to expectations of three rate cuts following the March meeting. Nevertheless, ongoing concerns about elevated inflation put some modest upward pressure on US bond yields, with the 10-year Treasury yield rising around 20bps in Q2.
The excessive focus on the timing of the first rate cut may obscure broader issues related to whether the Fed’s monetary policy is appropriate. The default policy rules considered by the Atlanta Fed’s Taylor Rule calculator all recommend lower rates than were prevailing at the end of the second quarter. This suggests that current Fed policy may be too restrictive, which increases downside risks to the economy. Though there were few signs in Q2 that a recession was imminent, we slightly lowered our 10-year US GDP growth forecast to 1.86% from 2% last quarter.
Meanwhile, the Fed has acknowledged modest progress toward bringing inflation back to target, but at the same time has bumped up its inflation forecasts. The most recent SEP, largely consistent with professional forecasters, is for PCE inflation to end the year at 2.6% before falling to 2.3% in 2025 and returning to 2% in 2026. The Fed’s implicit view is that the current level of restrictiveness needs to be kept to ensure those inflation forecasts are met. The 10-year inflation forecasts we use in our Capital Market Assumptions (CMAs) were little changed this quarter.
Although the Fed is still in wait-and-see mode for the time being, falling inflation has provided room for a number of other developed market central banks to cut rates in response to weak economic activity. In Europe, the struggling manufacturing sector continues to weigh on economic growth, but the European Central Bank (ECB) likely took some solace in core inflation falling back below 3% when cutting policy rates by 25bps in early June. Nevertheless, inflation remaining above its 2% target prevents the ECB from cutting rates too aggressively.
In contrast, the Bank of Japan (BoJ) remains an outlier among Developed Markets. In an effort to normalize policy as inflation returned following COVID, the BoJ ended its negative interest rate policy in March and has since been forced to bring rates up to 0.25% and slow asset purchases in order to stabilize the yen after significant depreciation over the course of Q2. The rate hikes and quantitative tightening come during a period of already weak Japanese economic activity and raise downside risks.
Long-Term Global Economic Outlook: We expect real economic growth in developed economies to continue to moderate over the next decade, as it has for the last 30 years. This is due to the limited growth of the developed labor force, which is constrained by domestic demographics. An assumption of no significant offset from improved productivity growth is an additional constraint on growth. Inflation in Developed Markets is also anticipated to moderate over the next 10 years, relative to the elevated rates of inflation observed in 2021 and 2022. Nevertheless, inflation is expected to be somewhat higher than in the period following the Global Financial Crisis of 2008 and prior to the COVID-induced recession of 2020. We expect long-run real economic growth and inflation in Emerging Markets to advance at higher annualized rates than in Developed Markets. Younger populations and higher rates of return on capital in Emerging Markets are driving higher rates of nominal economic output compared to Developed Markets.
Source: PGIM Quantitative Solutions as of 30-Jun-2024. Forecasts may not be achieved and are not a guarantee or reliable indicator of future results.
Equities: Our 10-year annualized nominal forecast return for Global Equities is 6.9%, a decrease from our forecast of 7.0% for the second quarter of 2024. The small forecast decrease is primarily attributable to less favorable valuations following a 3.0% advance in Global Equities in the second quarter of 2024. Our long-term return forecast for US Equities is somewhat lower, at 6.1%. Looking at the rest of the world, Developed Market Equities outside the US are forecast to return 8.5% and Emerging Market Equities are forecast to return 8.6% over the next 10 years. Cheaper valuations, as measured by historical valuation ratios, are driving stronger expected returns for non-US Developed Market Equities versus US Equities. While faster expected economic growth is a positive for Emerging Market Equities versus non-US Developed Market Equities, this effect is partially offset by relatively less attractive income returns.
Fixed Income: Global sovereign interest rates moved modestly higher in the second quarter of 2024 as expectations for global central bank rate cuts were pushed further out into 2024 amid a still-growing global economy and inflation that generally remained above central bank targets. Our long-run forecast for hedged Global Aggregate Bonds is 4.5%, an increase of 0.5% from our forecast from the prior quarter, due to the aforementioned increase in underlying sovereign rates. Our long-run forecast for US Aggregate Bonds is 4.8%, a slightly higher expected return relative to our forecast for Global Aggregate Bonds, attributable to higher initial yields partially offset by a positive contribution from hedging foreign currency exposure. At the end of our 10-year forecast horizon, we expect the Fed’s policy rate to be approximately 3.3%, which is about 200 basis points lower than the midpoint of the policy rate target range at the end of Q2 2024. Outside the US, Developed Market central banks (aside from Japan) are forecast to gradually decrease policy rates as inflation pressures subside and growth remains sluggish. In US credit markets, our forecast for average spreads over the next 10 years is somewhat higher than the spreads prevailing at the end of the second quarter of 2024, informing expected returns of 5.1% for both US Investment Grade (IG) and High Yield Bonds.
Real Assets: Real Assets are broadly defined to include asset classes that have physical properties or have returns that are highly correlated with inflation. We include Commodities, REITs, and TIPS as Real Assets in our CMAs. Our forecasts for these asset classes are expected to outperform our 10-year US inflation forecast of 2.7%.
Private Assets: Our forecasts for US Buyout Private Equity, US Venture Capital Private Equity, US Mezzanine Private Debt, and Global Private Infrastructure are linked to the forecast outcomes of public market assets with a premium consistent with historical empirical outcomes, acknowledging the underlying illiquidity and potential leverage employed in these asset classes relative to public market counterparts. Our forecasts for Core and Opportunistic US Private Real Estate are based on inputs from the NCREIF Property Indexes and linkages to forecast US economic growth and inflation.
Currency and Currency Hedging Returns: Over the next 10 years, we are forecasting generally negative returns for the US dollar relative to Developed Market peers, with outcomes ranging from an annualized loss of -0.4% for the Australian dollar to a gain of 1.1% for the Swiss franc. Forecast outcomes for Emerging Market currencies range from an expected loss of -2.5% for the South African rand to a gain of 0.8% for the Taiwan dollar. Long-term currency hedging returns against a market-weighted basket of Developed Market exposures are forecast to be net positive for US investors as short-term interest rates are anticipated to be higher over the long term in the US relative to the Eurozone and Japan.
60/40 Portfolio Return1: Based on our long-term forecasts, a balanced portfolio of 60% Global Equities unhedged and 40% Global Aggregate Bonds hedged is forecast to return 6.3% annually over the next 10 years, an increase of 0.1% from our forecast for the second quarter of 2024.
1For illustrative purposes only. All model portfolios have significant inherent shortcomings and do not consider many real-world frictions. There is no current PGIM Quantitative Solutions client portfolio with this composition of assets. It does not constitute investment advice and should not be used as the basis for any investment decision.
