Capital Market Assumptions
Five-Year Perspective

Last year’s edition highlighted a number of challenges for financial markets, including the persistence of elevated inflation, a dramatic inflection in monetary policy, and delays to the resumption of normal economic activity in the wake of the COVID pandemic. These challenges, along with unanticipated risks—particularly Russia’s invasion of Ukraine—made 2022 a difficult year for investors. At the outset of 2023, financial markets still face near-term headwinds, but investors with a longer-term perspective have some room for optimism, in our view.

The primary market theme in 2022 was inflation, which spurred belated action from central banks followed by an immediate reaction from financial markets. Fixed income assets were the most direct casualties of tighter monetary conditions, as bond markets experienced their worst performance in decades. Additionally, as rates moved higher, equity multiples contracted, and risk assets generally underperformed.

At the outset of 2023, global inflation rates appeared to be either near or at their peaks, but uncertainty remained about the monetary policy courses to be followed by the major central banks and their effects on economic growth. The prospect of recession may warrant near-term caution, but we believe a longer horizon—like the five-year term of these forecasts—supports a more positive outlook for investors.

Inflationary pressures, which first appeared in the U.S., have spread across the globe. Underlying economic strength also has put pressure on central banks to rein in inflation by raising risk-free rates. Our forecasts for real gross domestic product (GDP) anticipate middling economic performance over the next five years. While we expect inflation rates to ease, high starting points result in levels that are above central bank targets across most economic regions. Overall, our global GDP growth forecasts remain positive, supported by strong economic fundamentals but sensitive to the ongoing monetary tightening cycle.

Equity
Our five-year expectations for equity returns are significantly higher versus last year’s CMAs. Globally, our baseline forecast foresees resilient nominal earnings per share (EPS) growth and moderate support for equity prices through multiple expansion. With the economic recovery and the monetary cycle further along in the U.S. relative to the rest of the world, our forecast includes slightly higher non-U.S. equity returns. Underlying EPS growth expectations are comparable across regions, but disparate starting valuations result in varied return estimates. In particular, we expect emerging market (EM) equities to outperform developed markets. Within the developed markets, we expect the return leaders to be the U.K., Europe ex-U.K., and Australia.

Fixed Income
In previous years, regional interest-rate environments were largely characterized by their similarities—subdued inflation, modest economic outlooks, and low policy rates. In contrast, our expectations this year are for more distinct, asynchronous regional cycles. The U.S. yield curve stands out as the outlier in our interest-rate forecasts, as we foresee a moderate decline in rates across the curve over the next five years. In other regions, we expect cash and short rates to remain stable or to fall moderately—with the exception of Japan, where we anticipate continued pressure on the Bank of Japan to keep short rates lower for longer. Long rates are predicted to rise across all non-U.S. regions. Generally, our investment professionals expect yield curves to steepen, as central banks complete their hiking cycles and economic activity picks up towards the end of our forecast horizon. However, higher starting rates and greater expected carry, on average, should provide a material cushion for investors. As a result, expected total returns for most fixed income asset classes are meaningfully higher than in previous years’ CMAs.

Alternatives
Our more bullish expectations for public equity and fixed income markets carry through to our forecasts for alternative asset classes. We expect healthy equity risk premia to benefit many alternative strategies that have structural exposure to equities. In addition, we forecast marginally higher return premia for credit, duration, and EM exposure compared to last year’s CMAs.

However, structural return premia opportunities are offset by lower expectations for alpha generation. While we still believe that alternatives offer rich opportunities for active management, we believe the strongest performance tailwinds over the next five years will come from beta and risk premia.

United States
Our U.S. forecast incorporates our expectation that the inflation cycle will peak in the near term, and that tailwinds for performance will return in the latter stages of our forecast horizon. Within U.S. equities, earnings growth is expected to remain resilient, on average, over the period. We expect valuations to rise disproportionately for U.S. smallcap equities, translating into higher returns relative to the U.S. largecap universe.

With the Federal Reserve approaching the end of its hiking cycle, our forecast sees the U.S. yield curve reversing its current inversion. We expect the short end of the curve to see the largest declines, with cash rates falling by 60 basis points (bps) and the 2-year Treasury yield declining by 140 bps. The long end of the Treasury curve is forecast to see more moderate declines of 20-50 bps, depending on the maturity.

The U.S. equity and fixed income backdrops support our strong expectations for multi-asset portfolio returns. Below, we present five forecast scenarios for returns from a 50% global equity and 50% global fixed income U.S. dollar-hedged portfolio, along with historical returns for five-year periods ended December 31, 2022, 2017, and 2012. Our five-year forecast is relatively bullish versus the historical periods shown, reflecting a more attractive starting point for valuations and yields.