- Firms create capital markets assumptions because investors need to plug some market return expectations into their financial plans.
- Investors could use stock and market bond forecasts instead of backward-looking historical numbers.
Susan Dziubinski: I'm Susan Dziubinski with Morningstar. Each year Morningstar's Christine Benz compiles a list of stock and bond market forecasts from well-regarded asset-management firms. Christine is here today to discuss her latest round of forecasts and how investors can incorporate them into their portfolio planning.
Good to see you, Christine.
Christine Benz: Hi, Susan. Good to see you.
Why Firms Create Capital Market Assumptions
Dziubinski: Christine, we've heard a million times that it's impossible to figure out or predict what the market is going to do. So, why do firms basically try to do that every year by creating these forecasts?
Benz: I think most of these firms would agree that it's impossible to predict the market's direction over the very short-term, over the next year, for example. But firms create these capital markets forecasts or capital markets assumptions because they know that we all need to plug something into our financial plans to know how much help to expect from the market and how much of the heavy lifting we'll have to do in terms of our own savings rate. So, that's the basic idea that the capital markets assumptions are there to provide people with some market return expectations that in turn they can plug into a financial plan.
I would also say, Susan, one happy story that I've discovered just over the past couple of years is that increasingly firms seem much more comfortable putting out these assumptions. They used to sometimes keep them inside the firm, or you would need to register or whatever it is. Most firms do provide these capital markets assumptions. You can read their reports. You can really delve into how they arrive at the assumptions. So, there's a lot more transparency than there used to be, and I think that can be helpful for all of us who are attempting to do financial planning.
How Investors Should Use Capital Market Assumptions
Dziubinski: How exactly, Christine, should investors go about using the forecasts?
Benz: I would use them in exactly that way, Susan, where if you were using some sort of a retirement calculator or some sort of software to help you figure out whether you're on track to reach your goal, you can use these return expectations instead of backward-looking historical numbers. I would say that they are probably better because they incorporate the market's current valuation, they incorporate current yields, and so forth. So, I think it's a better starting point for most investors than simply taking the market's long-run returns, which may not repeat themselves, and using those.
Dziubinski: Let's dig into some of the numbers from the most recent roundup of forecasts that you did. Let's start with bonds, with the headline being that the forecast for bond returns has jumped quite a bit from what maybe we've seen in the past couple of years. Why is that?
Benz: Right. It's, I would say, a silver lining in what we've had in terms of the very rocky market that we've had for bonds and stocks. The fact that yields have come up so substantially over the past several months means that our bond return expectations are that much better, because income yield is the raw material for the returns that we earn as bond investors and yields are higher. So, even though they've caused some short-term dislocation in bond prices, the good news story is that the forecast is better now than it was at the beginning of this year. I wouldn't get too excited yet, though. When we looked at the forecast that firms who had updated their forecasts as of the first quarter or even midyear, most were expecting U.S. high-quality bond returns to be in the neighborhood of 3.0%, 3.5% and lower-quality bond returns to be somewhat better than that but with higher volatility. So, nothing to get super excited about yet, but nonetheless, a better-looking number than we had when yields were much, much lower even last year.
Dziubinski: Let's pivot over to equity returns. Now, those are looking better too, but there seems to be a broader range there of forecasts. Before we get into that, let's talk a little bit about how firms arrive at the forecasts when it comes to stocks in particular?
Benz: Firms have different methodologies, but many firms use a formula where they're looking at dividend yields, so the dividend yield on the stock market, as well as their expectation of price earnings multiple expansion or contraction, as well as their expectation of earnings growth expansion or contraction. And so, the big driver in terms of many firms' return expectations for equities elevating recently has been the fact that we have lower valuations. Most firms think that because of that they are expecting to see better equity market returns than they would have said at the end of 2021. So, when we surveyed the latest forecasts, it was kind of a convergence in the 6%-7% range for U.S. equities over the next decade, U.S. large-cap equities. Some firms are expecting better things for U.S. smaller companies.
And then, we also saw a consistent theme. This is something we've been seeing for the past several runs of data on these forecasts. Many firms are expecting to see better returns from non-U.S. stocks than U.S. stocks. That's been a recurrent theme, and that's something we've seen carry forward even into this year's down market, where firms are still forecasting better results for those overseas stocks. And the key reason there is that valuations are cheaper still.
Capital Market Forecasts and Your Portfolio
Dziubinski: Christine, then what are the implications of these latest forecasts for how investors should be thinking about or managing their portfolios?
Benz: I think the key thing I think about Susan is that there's kind of an interplay between your portfolio value and its forward-looking return prospects. So, at the end of 2021, when we were all feeling really good about ourselves, when our portfolios were at their largest, valuations were much higher, and return expectations were much, much lower. Bond yields were much lower as well. So, there's kind of this seesaw effect where when your portfolio balance is down, its return prospects are often up. So, I would bear that in mind. I would use that as an impetus to stick with whatever dollar-cost averaging plan I've set up for myself. I would also use it as an impetus to stick with whatever rebalancing program I've set up for myself. So, if I'm doing kind of that once annual review of my portfolio, which I think is plenty for most people, probably going to have to do some rebalancing, assuming that the trends we're seeing so far this year persist well into the second half of this year. You may have to top up the stocks. And I would say the fact that we are seeing now fairly robust return expectations for stocks, I think that should give you some comfort in doing that rebalancing, which oftentimes doesn't feel so great at the time.
Dziubinski: Well, Christine, thanks for the good news, because this all sounds quite nice to think about higher return expectations going forward. We appreciate your time.
Benz: Thank you so much, Susan.
Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.
Watch "3 Tax Strategies for a Bear Market" for more financial advice from Christine Benz.