Capital Market Assumptions

Capital Market Assumptions

Return expectations are an important element in estimating what to expect from portfolios over the longer term. Emotions drive markets in the short term, so no matter how good your information is, trying to guess where the market will be in a year is just that – a guess. In fact, research has shown that the statistics used to make short-term predictions have no near-term predictive power. So, we think making investment decisions on those guesses is a mistake. Over the longer-term, however, average returns, reversion to the mean for overpriced and underpriced assets, and long-term trends do have predictive power. Therefore, our capital market assumptions are based on expectations for average returns over the next 10 years.

Before getting into the numbers, a little preface is needed to give some insight as to the thinking behind these estimates. Stocks, measured by the S&P 500, gained 18.4% in 2020 and bonds, based on the US Investment Grade (Bloomberg) Aggregate index, gained 7.4%. Both of these returns are above their long term historic averages.

These returns come at the close of what was a particularly good decade for stocks. For the decade, stocks averaged an annual return of 13.9%. Albeit, this decade came on the heels of a poor decade for stocks, but we believe it is unlikely that above-average returns from stocks or bonds will continue over the next decade.  This is due simply to the already ultra-low levels of interest rates, the currently-high level of valuations on equities and bonds, and government deficits.  While the current boost from monetary and fiscal policy to deal with this pandemic should provide a tail wind for stock and bond valuations, we can’t expect it to last forever.  And though stock and bond valuations are not a good indicator that a correction is imminent, they are better indicators of whether returns over the next 10 years will be above or below historic averages.

While we expect rapid economic growth in the coming months as the world recovers from COVID-19, our goal is to look through the immediate impact of the virus and focus on the potential long-term trends in assets. Central bank intervention was a boon to equity markets in 2020. We believe (and hope) it will dissipate over time but also feel that a more active Fed is something we will live with for the foreseeable future. This intervention has led, and will continue to lead, to the increased correlation of asset classes. This relationship in the movement of asset prices has also been aided by the freer flow of capital around the globe and the better dissemination of information, so we expect this increased interdependence of asset classes to continue above historic norms. Consequently, diversification via traditional asset classes will be less effective, resulting in elevated portfolio volatility.

The elevated valuations of equities should present a headwind for stock prices going forward. Within this environment, over the next 10 years we expect domestic equities to provide an average annual return of 7.0%. Once we move beyond the pandemic rebound, we expect growth to resume its trend and be below that of its average since World War II. Coupled with stock values that are above historic norms, we think expectations above this would be optimistic. For comparison, the 95 year annualized return on domestic stocks has been 10.3%. However, the return over the last 20 years has only been 7.5% per year. We expect foreign developed equities to provide an annualized return of 6.3%, somewhat slower than domestic equities, despite lower valuations, due to the increased risks. While the reduction in interest rates has created an increase in home buying, real estate returns trailed stock returns last year and we expect this trend to continue with an estimate of 5.6% annualized growth. Global infrastructure also trailed and we anticipate the debts governments have run up could put strains on expanding infrastructure spending – at least outside of the US. Consequently, we see infrastructure growing at an average annual rate of 5.9%.

Current low yields translate into reduced expectations for high quality bonds. The Fed has changed its policy on fighting inflation and has stated that it will let inflation run above its 2% target before raising rates. This change, coupled with the COVID stimulus, could increase inflation pressures in the near term. However, because of the Fed’s new position on inflation, we would expect pressure on yields moving higher to be felt much more so on the long end of the yield curve than on the short end. Therefore, for high quality bonds of short to intermediate maturity, we expect returns to average 2.3%, below the 20 year average of 3.5%, but reasonable given how low current interest rates are.

Our risk management strategies provided the cushions we had expected during the market’s decline in 2020, with returns independent of the returns from both stocks and bonds. As a group we expect these strategies to provide returns of 3.3% annualized over the next 10 years.

So overall, given the current price of the markets and the expected economic growth here and abroad, we expect portfolio returns to fall below their long term averages but to be not too dissimilar from the returns achieved over the last 20 years.  

The views or opinions in this article are those of the author and do not necessarily represent the views of Washington Trust Bank or senior management. Washington Trust Bank believes that the information used in this article was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinions expressed constitute a solicitation for business or a recommendation for purchase or sale of securities, commodities or bank products.

About The Author

Rick Cloutier, PhD, CFA is the Chief Investment Strategist for Washington Trust Bank with over 25 years of portfolio management and investment experience. He is responsible for directing the portfolio management, research, and trading activities for the bank’s multi-asset class strategies. He is also responsible for overseeing the client portfolio manager team and portfolio analytics team. Rick has written numerous articles for Investopedia and wrote a weekly column for the Fall River Herald News in Massachusetts. His research has appeared in numerous journals, including the Journal of Investment Management and Financial Innovations, the Journal of Business Management and Economics, and the International Journal of Revenue Management. He provided a nightly commentary on WALE radio and authored the novel Caveat Emptor. Rick earned his BS from URI, MBA from Boston University and PhD from SMC University.