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At CAPTRUST, we believe setting realistic capital market assumptions
leads to more prudent asset allocation decisions for corporate
defined benefit plans and private investors alike and to a more
successful investment experience overall. In developing our new
assumptions, we expect monetary policy, rather than fiscal policy or
fundamental factors such as corporate earnings, will continue to drive
the performance of capital markets. Given these circumstances, we
suggest that now is the time for investors to reassess their portfolio
return expectations.
The financial literature has taught us
that risk and return are related and that
optimized portfolios seek to produce
the highest expected return per unit
of risk. But what returns are realistic
to expect in a post-financial-crisis
environment characterized by slower
economic growth, historically low
interest rates, and subdued inflation?
Formulating risk and return assumptions
for the various asset classes that
comprise capital markets offers
investors a guide to the probable range
of investment performance over a
given period. These assumptions can
then guide the asset allocation and
risk levels that should be chosen to
meet investment goals. For instance, if
equities are expected to deliver higher
returns in the forward period than
they have in the previous period, can
equity allocations be lowered without
sacrificing performance?
SUMMARY
CONSULTING RESEARCH GROUP | POSITION PAPER
www.captrustadvisors.com
capital market assumptions Seeking Opportunities in a More Challenging Environment
April 2013
2
CAPTRUST FINANCIAL ADVISORS
www.captrustadvisors.com
Overall, our new return forecasts are generally lower than our prior
forecasts, primarily due to a lower starting point across each asset class.
Historically low interest rates are driving more subdued fixed income
returns, while slower economic growth adversely impacts equity returns.
Despite lower return forecasts, we remain generally constructive on capital
markets. Going forward, however, investors will need to be more selective
with their asset allocation decisions.
Our forecast covers a full market cycle, which is typically five to seven years. We look at four
principal themes that guide our current thinking in formulating capital market assumptions.
1) Slower economic growth: Economic improvement following financial crises tends to
be shallower than in other recoveries. In recent years, growth has been held back by several
factors, including corporate and household deleveraging, but signs of progress are evident.
As shown in Figure 1, the household and financial sectors have made considerable strides
in reducing their debt burdens; debt-to-Gross Domestic Product (GDP) ratios for both of
these sectors are at decade lows. The corporate sector has made less progress on this issue,
but high cash levels on corporate balance sheets provide support. Given balance sheet
strength and cheap financing rates, we are less concerned about corporate indebtedness.
capital market assumptions Seeking Opportunities in a More Challenging Environment
GUIDING THEMES
Figure 1: Debt Outstanding by Sector as a Percentage of U.S. GDP, 1965–2012
100%
80%
40%
1970 1975 1980 1985 1990 1995 2000 2005 2010
140%
0%
120%
20%
60%
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Household
Corporate
Government
3CAPITAL MARKET ASSUMPTIONS — Seeking Opportunities in a More Challenging Environment
In contrast to private sector deleveraging, government debt
as a percentage of GDP continues to increase at a rapid
pace and is currently at historic highs. Academic research
suggests that a high debt-to-GDP ratio can have a materially
negative effect on a country’s economic growth.1 The fiscal
tightening that is necessary to address this issue, likely
through tax increases and spending cuts, could be a drag on
U.S. economic growth.
The key question over the forecast horizon is whether a
recovery in the U.S. private sector can offset contraction
in the government sector. Within the private sector,
homebuilding is beginning to recover and should provide
a tailwind for economic growth. In the early years of our
forecast, fiscal contraction is expected to offset better
growth prospects in the private sector. However, in the later
years of our forecast, assuming the government debt-to-
GDP ratio is reduced to a sustainable level, both the public
and private sectors could contribute to economic growth.
The International Monetary Fund (IMF) forecasts that U.S.
GDP growth will gradually return to its long-term trend
over the forecast horizon. Sluggish growth may be partially
attributed to shorter-term issues such as uncertainty about
the U.S. deleveraging process over the next year and the
European sovereign debt crisis. As clarity emerges on
these issues, business and consumer confidence will
likely improve. However, structural issues related to the
financial crisis such as longer-term debt reduction and a
persistently high unemployment rate may also impact
growth. Demographic factors such as an aging U.S.
population could also play a role, as the pace of labor force
growth slows. Some observers, such as the Congressional
Budget Office, are concerned that these structural factors
could impair the longer-term U.S. growth rate, although the
evidence is unclear at this point.2
2) Low interest rates: As shown in Figure 2, U.S.
interest rates have steadily fallen over the past 30 years
to historically low levels. The Federal Reserve expects to
keep short-term interest rates at the present low levels for
several more years, depending on the pace of improvement
in the labor market and the overall economy’s trajectory.
Interest rates could gradually rise toward equilibrium
levels in the latter part of our forecast horizon.
continued on page 4
CONSULTING RESEARCH GROUP | POSITION PAPER
Figure 2: U.S. 10-Year Government Bond Yields, 1975–2013
10%
8%
4%
16%
0%
Yie
ld
14%
2%
6%
12%
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),
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1975 1980 1985 1990 1995 2000 2005 2010
September 1981: 15.32%
May 1984: 13.41%
January 2000: 6.66%
December 2008: 2.42%
January 2013: 1.98%
4
CAPTRUST FINANCIAL ADVISORS
www.captrustadvisors.com
continued from page 3
While the Fed is expected to keep short-term rates
anchored in the near term, it has less direct control over
longer-term rates. Many investors are concerned that
longer-term interest rates can only go higher from today’s
historically low levels. As discussed later in this report, we
expect subdued returns in fixed income as interest rates
begin to rise.
However, low interest rates can have a favorable impact on
other aspects of the economy, including the deleveraging
process. In recent years, households and businesses have
refinanced their debt at significantly lower rates, which
reduces their future debt service cost.
3) Monetary policy: With fiscal policy constrained in
the developed world, monetary policy is a critical asset
class return determinant. Central bank actions not
only influence interest rates but also investor behavior
as evidenced by strong flows into higher-yielding asset
classes over the past year. According to Lipper, U.S. high
yield bond funds saw $29 billion of inflows in 2012, just
below the record inflows posted in 2003 and 2009. In
some cases, such as with global equities, monetary policy
could distort asset prices as investors pay less attention to
corporate earnings and other fundamental factors. Central
banks’ ability to successfully unwind their accommodative
policies will also have a significant impact on asset prices,
although this is more likely to be a factor in the latter part
of the forecast horizon.
4) Inflation: U.S. inflation, as measured by the
Consumer Price Index (CPI) (Figure 3), has been well-
contained in recent years due to sluggish GDP growth
and considerable slack in the economy. This scenario has
kept wage growth at low levels. We expect inflation to
remain subdued in the near term but pick up in the later
years of our forecast due to the impact of accommodative
monetary policy and stronger economic growth.
Some observers are concerned that the aggressive steps
taken by central banks could eventually lead to higher
inflation. The Fed’s balance sheet has expanded significantly
following the financial crisis, driven by its purchases of
U.S. Treasurys and mortgage-backed securities. The Fed’s
balance sheet should continue to expand in the near term
and could reach $4 trillion by the end of 2013 based on
the current pace of asset purchases. The European Central
Bank has embarked on a similar program in response to that
region’s sovereign debt crisis.
The U.S. money multiplier, which measures the amount
of commercial bank money that can be created by a given
unit of central bank money, remains at a historically low
level (Figure 4), which dilutes the impact of monetary
policy. A contraction in bank lending due to tighter lending
standards and lower loan demand is the main driver behind
this trend. As the money multiplier normalizes due to a
pickup in bank lending, we will likely see higher inflation
during the later years of our forecast horizon.
5CAPITAL MARKET ASSUMPTIONS — Seeking Opportunities in a More Challenging Environment
These four themes could have a
significant impact on asset class
results during our forecast horizon.
The balance between private sector
growth and public sector deleveraging
is a significant swing factor in our
forecasts. Market observers who are
pessimistic on U.S. growth often
cite the drag from fiscal contraction
as a primary reason. The future path
of interest rates is meaningful to
our forecasts, particularly for fixed
income. If longer-term rates stay low
for an extended period, this could be
supportive for fixed income returns.
In contrast, if rates normalize faster
than expected due to acceleration
in economic growth, fixed income
returns could be adversely impacted.
Accommodative monetary policy
could lead to higher than expected
inflation, with adverse effects on a
number of asset classes, particularly
fixed income. In that scenario, hard
assets such as commodities and real
estate could become relatively more
attractive as they have historically
acted as hedges against inflation risk.
continued on page 6
CONSULTING RESEARCH GROUP | POSITION PAPER
Figure 3: U.S. Consumer Price Index, 1950–2012
10%
8%
4%
14%
-2%
Infl
atio
n
12%
2%
6%
0%
Figure 4: U.S. Money Multiplier, 1960–2012
10x
8x
4x
14x
Mul
tip
ler
12x
2x
6xS
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1950 1960 1970 1980 1990 2000 2010
1960 1970 1980 1990 2000 2010
Average = 4%
Average = 9.4x
6
CAPTRUST FINANCIAL ADVISORS
www.captrustadvisors.com
continued from page 5
We divide our full market cycle forecast horizon into two periods:
• Years 1-3: continuation of slow GDP growth, low interest rates, and modest inflation
• Years 4-7: gradual acceleration of GDP growth leading to higher interest rates and inflation
Please note that our forecasts are at the asset class level only; we do not forecast the excess returns
derived from the use of active management.
As shown in Figure 5, our new return forecasts are lower than our prior forecasts across nearly every asset
class. When developing capital market assumptions, the starting point for each asset class is an important
consideration since it historically has a high correlation with future returns. Historically low interest rates
drive our more subdued fixed income returns, most notably in rate-sensitive subsectors such as long-term
Treasurys and core fixed income. Slower economic growth is filtering into corporate profits, which drives
our equity returns lower. Equity valuations have rebounded following the financial crisis, which suggests a
lower probability of multiple expansion (investors paying a higher price per unit of earnings) going forward.
OVERVIEW OF NEW ASSUMPTIONS
Asset Class Prior Return New Return Prior Risk New Risk
U.S. GDP Growth — 2.5% — —
U.S. Inflation 3.0% 2.6% — —
Cash 1.5% 1.2% 0.5% 0.5%
Long-term U.S. Treasury — 1.8% — 12.1%
Core Fixed Income 5.0% 2.5% 5.1% 5.5%
U.S. Investment Grade Corporate 5.8% 3.6% 6.9% 6.1%
Long Duration Corporate — 5.0% — 11.3%
U.S. High Yield Corporate 6.1% 7.0% 9.7% 15.0%
Emerging Market Debt — 5.8% — 13.0%
U.S. Municipal Debt 5.8% 2.7% 4.9% 4.9%
U.S. Large-cap Equity 8.1% 7.0% 15.3% 17.4%
U.S. Mid-cap Equity 9.3% 7.5% 18.5% 20.6%
U.S. Small-cap Equity 9.5% 7.3% 22.9% 22.5%
International Equity — Developed 9.3% 7.6% 19.3% 25.0%
International Equity — Emerging 12.0% 9.3% 28.0% 27.2%
Private Equity 13.0% 10.0% 26.5% 28.8%
U.S. Public Real Estate 7.4% 7.2% 15.9% 22.8%
U.S. Private Real Estate 9.0% 6.2% 18.9% 12.5%
Commodities 8.6% 6.0% 21.0% 19.7%
Hedge Fund of Funds (Diversified) 8.5% 4.0% 5.5% 5.0%
Figure 5: Comparison of New and Prior Capital Market Assumptions
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7CAPITAL MARKET ASSUMPTIONS — Seeking Opportunities in a More Challenging Environment
continued on page 8
You’ll see that our new risk forecasts are higher than our prior risk forecasts across most
asset classes. We use standard deviation as one risk metric, which measures the possible
divergence of the actual return for an asset class from its expected return. Note that for
our portfolio construction processes, we view permanent capital impairment or loss of
capital as the single most important risk measurement. Our standard deviation forecasts
in Figure 6 are based on historical trends with more weight placed on recent periods. For
nearly all asset classes, standard deviations in the most recent five-year period are higher
than over the prior 20 years. The deleveraging process and other repercussions from the
financial crisis have driven increased volatility in economic growth and asset prices. The
trend of increased volatility is expected to continue in the coming years.
CONSULTING RESEARCH GROUP | POSITION PAPER
Historical Standard Deviation Difference Standard
Deviation
Asset Class 20 Years 10 Years 5 Years 5 Yr – 20 Yr Forecast
Cash 0.6% 0.5% 0.5% -0.1% 0.5%
Long-term U.S. Treasury 9.8% 11.3% 12.9% 3.1% 12.1%
Core Fixed Income 3.7% 3.6% 3.5% -0.2% 5.5%
U.S. Investment Grade Corporate 5.3% 5.7% 6.4% 1.1% 6.1%
Long Duration Corporate 8.8% 10.6% 12.1% 3.3% 11.3%
U.S. High Yield Corporate 8.9% 10.9% 13.5% 4.6% 15.0%
Emerging Market Debt — 9.1% 10.4% 1.4% 13.0%
U.S. Municipal Debt 4.4% 4.6% 5.0% 0.6% 4.9%
U.S. Large-cap Equity 14.9% 15.7% 18.2% 3.3% 17.4%
U.S. Mid-cap Equity 16.7% 18.3% 21.9% 5.2% 20.6%
U.S. Small-cap Equity 19.5% 20.7% 23.5% 4.0% 22.5%
International Equity — Developed 17.0% 18.8% 22.3% 5.3% 25.0%
International Equity — Emerging 24.0% 24.1% 28.3% 4.3% 27.2%
Private Equity 11.0% 10.9% 11.5% 0.5% 28.8%
U.S. Public Real Estate 19.8% 25.1% 31.7% 11.8% 22.8%
U.S. Private Real Estate 4.9% 6.2% 7.7% 2.8% 12.5%
Commodities 15.3% 18.2% 21.1% 5.8% 19.7%
Hedge Fund of Funds (Diversified) 4.0% 4.3% 5.4% 1.3% 5.0%
Figure 6: Standard Deviation Forecasts
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CAPTRUST FINANCIAL ADVISORS
www.captrustadvisors.com
continued from page 7
Expected risk-adjusted returns for each asset class based
on the Sharpe ratio, which divides CAPTRUST’s expected
return by our expected standard deviation, are displayed in
Figure 7. Sharpe ratio is a helpful measure since it allows for
comparison across asset classes. For example, although hedge
fund of funds have a low expected return of 4%, risk-adjusted
returns are more favorable. In contrast, private equity has both
a high expected return and standard deviation, which leads to
a lower Sharpe ratio. Within fixed income, our analysis reveals
that credit-sensitive subsectors are more attractive than rate-
sensitive areas. Equities generally screen near the average level
among the asset classes in our capital market assumptions.
Sharpe ratio is a
helpful measure
since it allows for
comparison across
asset classes.
Figure 7: Risk-Adjusted Returns
Hedge Fund of Funds (Diversified)
Long-Term U.S. Treasury
0.0
Sharpe Ratio
U.S. Private Real Estate
U.S. Investment Grade Corp
U.S. High Yield Corporate
Emerging Market Debt
Long Duration Corporate
U.S. Large-Cap Equity
U.S. Municipal Debt
U.S. Mid-Cap Equity
Private Equity
International Equity—Emerging
U.S. Small-Cap Equity
U.S. Public Real Estate
International Equity—Developed
Commodities
0.1 0.2 0.3 0.4 0.5 0.6
Core Fixed Income
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9CAPITAL MARKET ASSUMPTIONS — Seeking Opportunities in a More Challenging Environment
continued on page 10
Our correlation forecasts (Figure 8) are derived from the same methodology as our risk
assumptions. Correlations among and within asset classes have generally increased in
recent periods as macroeconomic issues and central bank actions drive markets. Given
this trend, we place more weight on recent periods when developing correlation forecasts.
CONSULTING RESEARCH GROUP | POSITION PAPER
Cas
h
Long
-Ter
m T
reas
ury
Co
re F
ixed
Inco
me
U.S
. Inv
estm
ent
Gra
de
Co
rpo
rate
Long
Dur
atio
n C
orp
ora
te
U.S
. Hig
h Y
ield
C
orp
ora
te
Em
erg
ing
Mar
ket
Deb
t
U.S
. Mun
icip
al D
ebt
U.S
. Lar
ge-
Cap
Eq
uity
U.S
. Mid
-Cap
Eq
uity
U.S
. Sm
all-
Cap
Eq
uity
Inte
rnat
iona
l E
qui
ty—
Dev
elo
ped
Inte
rnat
iona
l E
qui
ty—
Em
erg
ing
Pri
vate
Eq
uity
U.S
. Pub
lic R
eal E
stat
e
U.S
. Pri
vate
R
eal E
stat
e
Co
mm
od
itie
s
Hed
ge
Fun
d o
f F
und
s
Cash 1.00 -0.02 -0.01 -0.12 -0.15 -0.17 -0.14 -0.11 -0.06 -0.08 -0.09 -0.04 -0.01 0.06 -0.11 0.28 0.04 0.08
Long-Term Treasury -0.02 1.00 0.78 0.46 0.56 -0.25 0.11 0.29 -0.28 -0.31 -0.33 -0.27 -0.27 -0.53 -0.16 0.03 -0.22 -0.34
Core Fixed Income -0.01 0.78 1.00 0.84 0.81 0.22 0.57 0.49 0.07 0.06 -0.02 0.14 0.11 -0.33 0.16 -0.13 0.08 -0.01
U.S. Investment Grade Corporate -0.12 0.46 0.84 1.00 0.95 0.58 0.78 0.56 0.36 0.38 0.28 0.46 0.42 0.11 0.37 -0.19 0.31 0.35
Long Duration Corporate -0.15 0.56 0.81 0.95 1.00 0.52 0.72 0.49 0.31 0.33 0.25 0.40 0.37 0.07 0.35 -0.14 0.24 0.27
U.S. High Yield Corporate -0.17 -0.25 0.22 0.58 0.52 1.00 0.78 0.35 0.72 0.78 0.72 0.73 0.73 0.65 0.73 -0.07 0.48 0.64
Emerging Market Debt -0.14 0.11 0.57 0.78 0.72 0.78 1.00 0.43 0.63 0.66 0.58 0.70 0.71 0.55 0.61 -0.04 0.51 0.53
U.S. Municipal Debt -0.11 0.29 0.49 0.56 0.49 0.35 0.43 1.00 0.12 0.16 0.08 0.12 0.11 0.01 0.19 -0.19 -0.05 0.20
U.S. Large-Cap Equity -0.06 -0.28 0.07 0.36 0.31 0.72 0.63 0.12 1.00 0.96 0.91 0.89 0.81 0.82 0.75 0.23 0.52 0.62
U.S. Mid-Cap Equity -0.08 -0.31 0.06 0.38 0.33 0.78 0.66 0.16 0.96 1.00 0.96 0.87 0.83 0.83 0.80 0.18 0.55 0.67
U.S. Small-Cap Equity -0.09 -0.33 -0.02 0.28 0.25 0.72 0.58 0.08 0.91 0.96 1.00 0.81 0.77 0.77 0.80 0.19 0.46 0.56
International Equity—Developed -0.04 -0.27 0.14 0.46 0.40 0.73 0.70 0.12 0.89 0.87 0.81 1.00 0.88 0.76 0.69 0.13 0.62 0.67
International Equity—Emerging -0.01 -0.27 0.11 0.42 0.37 0.73 0.71 0.11 0.81 0.83 0.77 0.88 1.00 0.72 0.60 0.04 0.65 0.70
Private Equity 0.06 -0.53 -0.33 0.11 0.07 0.65 0.55 0.01 0.82 0.83 0.77 0.76 0.72 1.00 0.61 0.50 0.64 0.87
U.S. Public Real Estate -0.11 -0.16 0.16 0.37 0.35 0.73 0.61 0.19 0.75 0.80 0.80 0.69 0.60 0.61 1.00 0.23 0.37 0.37
U.S. Private Real Estate 0.28 0.03 -0.13 -0.19 -0.14 -0.07 -0.04 -0.19 0.23 0.18 0.19 0.13 0.04 0.50 0.23 1.00 0.30 0.28
Commodities 0.04 -0.22 0.08 0.31 0.24 0.48 0.51 -0.05 0.52 0.55 0.46 0.62 0.65 0.64 0.37 0.30 1.00 0.65
Hedge Fund of Funds 0.08 -0.34 -0.01 0.35 0.27 0.64 0.53 0.20 0.62 0.67 0.56 0.67 0.70 0.87 0.37 0.28 0.65 1.00
Figure 8: Correlation Matrix
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CAPTRUST FINANCIAL ADVISORS
www.captrustadvisors.com
continued from page 9
GDP and Inflation
Dividing the full market cycle into two periods, as
discussed earlier, forms the basis for our long-term 2.5%
U.S. GDP growth forecast. In years one through three,
the impact of deleveraging is expected to keep GDP
growth below its long-term average. In years four through
seven, fiscal contraction becomes less of a drag and GDP
growth accelerates.
In a similar fashion, the expectation for a slow growth
period followed by a stronger one underpins our 2.6%
U.S. inflation forecast. In years one through three, the
money multiplier stays below its long-term average and
considerable slack remains in the economy, particularly
in the labor market, keeping inflation contained. In years
four through seven, inflation rises due to the impact of
central banks’ accommodative monetary policies and a
tighter labor market.
Gradual recoveries in GDP growth and inflation have a
significant impact on our equity return forecasts, as these
conditions lead to lower earnings growth compared to
historical averages. Inflation expectations normally have a
negative correlation with fixed income returns. If inflation
remains well controlled, this could be supportive for fixed
income. In contrast, hard assets such as commodities and
real estate tend to perform well in inflationary environments.
Fixed Income
The current yield is the starting point for our fixed income
forecasts as it has been a reasonable proxy for forward fixed
income returns with a correlation of 0.90 (see Figure 9). With
the 10-Year Treasury yield hovering around 2%, this could
signal subdued fixed income returns in future years. Fixed
income returns have diminished over time as interest rates
approach the nominal “zero bound,” a term reflecting that
in unadjusted terms, bond yields cannot move below zero.
ASSET CLASS METHODOLOGY AND IMPLICATIONS
Figure 9: 30-Year U.S. Treasury Yield vs. Barclay’s U.S. Aggregate Index, 1977–2012
1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2004 2006 2008 20102002 2012
10%
8%
4%
20%
0%
16%
2%
6%
12%
18%
14%
10-Year Treasury Yield (Beginning of Year)
Barclays U.S. Aggregate (5-Year Forward Return)
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11CAPITAL MARKET ASSUMPTIONS — Seeking Opportunities in a More Challenging Environment
continued on page 12
The biggest risk for fixed income returns is a sharp rise in interest rates,
but several factors could prevent this scenario. Despite accommodative
monetary policy from central banks, risks to global growth remain a concern,
which could lead to a more gradual increase in interest rates. In addition,
demographic factors in the U.S. and a lack of viable substitutes for U.S.
Treasurys as a safe haven asset could provide support even as rates rise.
Our cash and long-term U.S. Treasury forecasts incorporate insights from
the forward yield curve, which represents market participants’ expectations
for future interest rates. The forward curve suggests a gradual rise in interest
rates over the coming years. For long-term U.S. Treasurys, we also factor in
the potential for principal loss in a rising rate environment. We examined
prior periods of rising interest rates to gauge the likely path of future returns,
which showed that Treasurys are more vulnerable to losses than other fixed
income subsectors.
For the remaining fixed income subsectors, we use the current yield as the
starting point and then make adjustments for expected spread tightening,
which could aid returns. U.S. investment grade and high yield spreads have
tightened significantly over the past few years albeit from elevated levels
during the financial crisis. In some cases, spreads could eventually reach
their pre-crisis lows due to improved fundamentals and investor appetite for
yield in the current low rate environment.
For high yield debt, the expected default rate is also incorporated into our
return forecast. U.S. high yield default rates have improved for several years
but are expected to gradually increase going forward. Default rates are
unlikely to rise sharply in the near term due to ample liquidity that provides
refinancing opportunities for companies.
Equities
We use three building blocks to develop equity return forecasts: dividend
yield, expected earnings growth, and the impact from valuation changes. Our
estimates for each return component are illustrated in Figure 10. The sum of
current dividends and earnings growth is a reasonable proxy for forward equity
returns with a correlation of 0.60. This measurement is currently about 6.5%,
which is slightly below our 7.0% return forecast for large-cap U.S. equities.
Despite accommodative
monetary policy from
central banks, risks to
global growth remain
a concern, which could
lead to a more gradual
increase in interest rates.
CONSULTING RESEARCH GROUP | POSITION PAPER
12
CAPTRUST FINANCIAL ADVISORS
www.captrustadvisors.com
continued from page 11
Dividend yields should be supported by a high level of cash on corporate balance sheets and a focus
on returning more capital to shareholders through actions including share buybacks. In a slow-growth
environment, yield has become an increasingly important component of total returns for equities.
During our forecast horizon, earnings growth for large-cap U.S. earnings is expected to be significantly
lower than its historical average of 8% as companies face revenue pressure and less flexibility to further
reduce costs. Earnings growth of 4.9% for large-cap U.S. equities is projected to be roughly in line with
our expectation for accelerated U.S. GDP growth in the latter part of our forecast horizon, with modestly
higher earnings growth for mid- and small-cap firms. In international equities, earnings growth in the
emerging markets should outpace the developed markets due to a better fiscal position and favorable
demographics. However, emerging market growth may be lower than in previous periods as China
transitions to a more sustainable growth rate.
U.S. Large-Cap U.S. Mid-Cap U.S. Small-Cap International Developed
International Emerging
Dividend Yield 2.1% 1.8% 1.6% 3.2% 2.8%
Earnings Growth 4.9% 5.7% 5.7% 3.5% 6.5%
Valuation Impact – – – 0.9% –
Total Return 7.0% 7.5% 7.3% 7.6% 9.3%
Figure 10: Equity Building Blocks
Figure 11: S&P P/E Ratio on 10-Year Normalized EPS, 1925–2012
30%
20%
10%
45%
0%
40%
5%
15%
1925 1930 1935 1940 1950 1960 1970 1980 1990 20001945 1955 1965 1975 1985 1995 2005 2010
25%
35%
So
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: CA
PT
RU
ST
Res
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So
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: P/E
: Ro
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Average = 17.4%
13CAPITAL MARKET ASSUMPTIONS — Seeking Opportunities in a More Challenging Environment
continued on page 14
For most equity categories, we do not model any valuation
impact. Figure 11 depicts the S&P 500 price-to-earnings
(P/E) based on the average of the prior 10 years of
earnings (inflation adjusted). This metric was developed by
economist Robert Shiller and is referred to as the “Shiller
P/E ratio.” Many observers consider it a more stable measure
of valuation that has relevance for long-term equity returns
since it extends over one or two business cycles.
While below its prior peaks, the current Shiller P/E is
higher than it has been 70% of the time since 1926. Long-
term expected returns normally decline as the starting
level of valuation increases.
We forecast a positive valuation impact for international
developed equities, as they are trading at a historically low
valuation level. Concerns about the European sovereign debt
crisis are now likely reflected in the market, so a favorable
resolution in the coming years could lead to modest multiple
expansion. While Europe’s growth outlook remains weak,
financial conditions have recently improved due to the more
aggressive steps taken by the European Central Bank.
Commodities
Nominal global GDP growth is used as a reasonable proxy
for commodity returns. As with equities, slower global
economic growth (as shown in Figure 12) leads to lower
commodity returns compared to our prior forecast. In
particular, the transition of China’s economy to a more
sustainable growth level could impact commodity returns.
China accounts for a large percentage of global demand in
many commodities, so changes in its growth trajectory can
be meaningful. Although commodity returns are forecast
to be lower than those of equities, commodities could be a
useful hedge against higher-than-expected inflation.
CONSULTING RESEARCH GROUP | POSITION PAPER
Figure 12: Global Nominal GDP Growth (%), 1981–2011
10%
8%
4%
14%
0%
12%
2%
6%
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1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2004 2006 2008 20102002
14
CAPTRUST FINANCIAL ADVISORS
www.captrustadvisors.com
continued from page 13
Private Equity
To derive private equity returns, we add an illiquidity premium to our U.S. large-cap equity
forecast. Investors expect to be compensated for the illiquidity risk that is inherent in private
equity, so it has both the highest expected return and highest expected risk of all the asset
classes in our forecast. The excess return of private equity has diminished in recent years
following strong returns in the pre-crisis period. The dispersion of individual manager returns is
wide within private equity, so manager selection is important to fully capture the benefit of this
asset class. Our private equity forecast is based on a broad index and does not incorporate the
benefits of individual manager skill.
Real Estate
For public real estate (REITs), we use the same three building blocks as equities (dividend
yield, earnings growth, and valuation impact). Solid dividend yields and earnings growth
are partially offset by multiple contraction, as valuations are above their historical level.
Commercial real estate fundamentals remain favorable, with high occupancy levels and
continued increases in rent.
Hedge Fund of Funds
Figure 13 displays a multi-factor model
used to identify the components of hedge
fund returns. The model is driven by the
cash forecast, which leads to a subdued
return expectation for the broad hedge
fund-of-funds category. We expect the
environment to remain challenging for
hedge funds due to historically high
correlations both within and among asset
classes. However, hedge funds provide
higher risk-adjusted returns than some
asset classes. As with private equity,
hedge fund returns are characterized by
a large amount of dispersion so manager
selection is crucial for this asset class.
Factor Model *Current Weight
Avg. Weight 2003–present
S&P 500 Total Return Index 5.5% -6.2%
Russell 2000 Total Return Index 3.1% 8.8%
MSCI EAFE Net Total Return Index 15.1% 13.5%
MSCI Emerging Markets Total Return Index 11.0% 13.3%
USD-EUR Spot Rate 6.6% 3.3%
One-Month USD LIBOR 65.3% 70.6%
Total (excludes USD-EUR spot rate) 100.0% 100.0%
Figure 13: Hedge Fund Factor Model
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*as of November 2012
15CAPITAL MARKET ASSUMPTIONS — Seeking Opportunities in a More Challenging Environment
Despite lower return forecasts across most asset classes, we remain
generally constructive on capital markets. Following a multi-decade
bull market in fixed income and facing the prospect of rising interest
rates, it may be tempting for investors to abandon this asset class.
However, we continue to believe that fixed income has an important
role to play in client portfolios. It has historically been a less volatile
asset class and provided a cushion during times of economic stress.
Nevertheless, we expect subdued returns for fixed income going
forward, so investors will need to be more selective with their asset
allocation decisions in this area. While economic growth prospects are
not robust, traditionally riskier assets such as equities could still provide
solid returns over the forecast horizon. Accommodative monetary policy
provides an incentive for investors to move away from lower-yielding
asset classes. Equities do not appear inexpensive on an absolute basis,
but they do look compelling relative to fixed income—subject to one’s
risk tolerance and time horizon. We are less constructive on commodity
returns due to slower global growth, although they could still play a role
in portfolios as an inflation hedge. Real estate currently has perhaps the
best fundamentals of any asset class due to favorable supply/demand
dynamics, although valuation metrics appear full. Alternative assets
such as private equity and hedge funds can benefit from individual
manager skill and are often less correlated with traditional asset classes.
If correlations, both within and between asset classes, return to more
normalized levels, this could provide a more favorable environment for
hedge fund strategies to add value. n
CONCLUSION
Sources:1 Reinhart, Carmen M., and Kenneth S. Rogoff. “Growth in a Time of Debt.” American Economic Review 100.2 (2010): 577.2 Congressional Budget Office. An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022. August 2012, pp 40-41.
CONSULTING RESEARCH GROUP | POSITION PAPER
CONSULTING RESEARCH GROUP | POSITION PAPER
www.captrustadvisors.com
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The opinions expressed in this report are subject to change without notice. This material has been prepared or is distributed
solely for informational purposes and is not tax or legal advice. This is not a solicitation or an offer to buy any security or
instrument or to participate in any trading strategy. The information and statistics in this report are from sources believed
to be reliable, but are not warranted by CAPTRUST Financial Advisors to be accurate or complete. The analyses are based
on hypothetical scenarios using various assumptions as detailed in each example and are not intended to illustrate the
experience of any particular investor or plan participant.
All Publication Rights Reserved. No portion of the information contained in this publication may be reproduced in any form
without the permission of CAPTRUST: 919.870.6822
© 2013 CAPTRUST Financial Advisors. Member FINRA/SIPC.
Hunter Brackett, CFASenior Manager CAPTRUST Consulting Research Group
ABOUT THE AUTHOR:
Hunter joined CAPTRUST in 2012 and works in the Investment Research
division, where he focuses on strategic and tactical asset allocation for client
portfolios. Prior to joining CAPTRUST, Hunter served with firms such as
NCM Capital where he managed the firm’s financial sector exposure across
all equity portfolios for their institutional and high-net-worth clients. He
was also an Associate, Large/Mid-Cap Banks at Lehman Brothers, Equity
Research Division, and an International Corporate Banking Associate at First
Union Corporation. Hunter is a graduate of Washington and Lee University
with a BA in economics, received his MBA from UNC Kenan-Flagler
Business School, and holds a CFA® designation.