June 2022 / OUTLOOK
Capital Market Assumptions
The pronounced shift in Fed Policy over the past few months may have a meaningful impact on asset allocators and the configuration of portfolios. This is because expected cash rates have re-rated higher due to rising inflation concerns and are expected to stay elevated based on forward rates. And higher cash rates, typically translate into higher capital market assumptions (CMAs), because of the foundational role cash plays in developing CMAs.
After the global financial crisis (GFC), long-term CMAs were meaningfully lower compared to previous decades partly because cash rates were expected to be structurally lower as global central banks moved to more accommodative monetary policy. Today, the market is anticipating that the U.S. Federal Reserve will raise short-term rates to almost 3% by the end of the year. This potential shift calls into question whether the post-GFC expectations for cash are too low and whether resulting CMAs are due for an upward shift.
Two Distinct Policy Regimes: What’s Next?
U.S. Generic 3-Month Bill Index, December 31, 1990- to May 31, 2022
Capital Market Assumptions on the Rise
We produce our annual CMAs in the fall of the prior year, and there is typically little reason to make interim changes. Because of the accelerated pivot by the Fed leading to materially higher expectations for cash rates and yields, had we completed this exercise today, our CMAs would broadly be 1%-2% higher for equities and bonds, and consequently balanced portfolios.
Implications for Investors
We always find it helpful to revisit our asset allocation playbook as market environments shift. And while the environment does not call for a new playbook, it may warrant a different play.
Strategic Asset Allocation Playbook
Does not change the playbook, but maybe the play
This shift allows allocators to consider different approaches to achieving return and risk objectives that may not have been considered previously. We recommend an incremental approach given the current uncertainty in inflation and growth (and the Fed response). But it’s not too early to begin thinking about how this change could impact your decisions for generating return and managing risk.
T. Rowe Price Capital Market Assumptions: The information presented herein is shown for illustrative, informational purposes only. Forecasts are based on subjective estimates about market environments that may never occur. This material does not reflect the actual returns of any portfolio/strategy and dis not indicative of future results. The historical returns used as a basis for this analysis are based on information gathered by T. Rowe Price and from third-party sources and have not been independently verified. The asset classes referenced in our capital market assumptions are represented by broad-based indices, which have been selected because they are well known and are easily recognizable by investors. Indices have limitations due to materially different characteristics from an actual investment portfolio in terms of security holdings, sector weightings, volatility, and asset allocation. Therefore, returns and volatility of a portfolio may differ from those of the index. Management fees, transaction costs, taxes, and potential expenses are not considered and would reduce returns. Expected returns for each asset class can be conditional on economic scenarios; in the event a particular scenario comes to pass, actual returns could be significantly higher or lower than forecast.
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