2023 Capital Markets Assumptions

Posted: May 8th, 2023 | Author:

How Are Capital Markets Projections Constructed?

Guiding objectives and process

Underlying beliefs guide the development of the projections

  • An initial bias toward long-run averages
  • A conservative bias
  • An awareness of risk premiums
  • A presumption that markets are ultimately clear and rational

Reflect our beliefs that long-term equilibrium relationships between the capital markets and lasting trends in global economic growth are key drivers to setting capital markets expectations

Long-term compensated risk premiums represent “beta”—exposure to each broad market, whether traditional or “exotic,” with limited dependence on successful realization of alpha

The projection process is built around several key building blocks

  • Advanced modeling at the individual asset class level (e.g., a detailed bond model, an equity model)
  • A path for interest rates and inflation
  • A cohesive economic outlook
  • A framework that encompasses Callan beliefs about the long-term operation and efficiencies of the capital markets

2023 vs. 2022 Risk and Returns Assumptions

Summary of Callan’s Long-Term Capital Markets Assumptions (2023–2032)

Current Market Conditions

Equity and Fixed Income Markets Down Together in 2022

Negative returns for stocks and bonds at the same time for three quarters are extremely unusual

Global equity markets down sharply in 2022 despite rebound in 4Q
Similar impact across all equity market segments: developed, emerging, small cap

Fixed income down with sharply higher inflation and interest rates
Bloomberg Aggregate: -13% for the year, worst year ever for the index by a wide margin
CPI-U: +6.5% for the year ended Dec. 2022

  • Number of times stocks and bonds have been down together
    • 38 quarters in almost 100 years, about 10% of the quarters
    • But just twice on annual basis
  • Inflation at highest rate in decades
  • Economic data show growth hit ‘pause’
    • GDP rose 3.2% in 3Q22 after falling in both 2Q and 1Q; consensus estimate is 1% for 4Q
    • Forecasters have cut growth estimates for 2022 close to 0%, and to 1.5% for 2023.
*Cambridge PE data through 06/30/22. CS Hedge Fund Index data through 09/30/22.

2022 Equity Drawdown: A More ‘Typical’ Correction?

S&P 500 Cumulative Returns
Market Peak-to-Trough for Recent Corrections vs. 2022 Through 12/31/22

Trading Days From Market Peak

  • While the COVID correction was swift and intense, the 2022 correction resembles the GFC and Dot-Com Bubble.
  • The 2022 drawdown has been 250 trading days through December.
  • It would take another 105 trading days to get to the bottom of the GFC and 275 trading days to get to the bottom of the Tech Bubble.

Did Diversification Fail in 2022?

Stocks and bonds down together in each of the first three quarters of 2022; up together in 4Q22

Rolling 1 Year Correlation of S&P 500 to Bloomberg Aggregate for 45 Years Ended 12/31/22

Are we seeing a return to a regime of higher correlation between stocks and bonds, potentially lessening the diversification benefit of bonds to stocks?

10-Year vs. 2-Year Treasury Spread

  • The 10-year to 2-year Treasury spread went negative two days in April and has been negative for most of 3Q and 4Q.
  • Inversion in this spread does not always forecast a recession, but most recessions are preceded by a yield curve inversion.
    • Yield curve inversion means investors expect a recession will occur and that interest rates will be cut, and therefore increase their demand for securities with longer duration, and therefore a higher potential for capital gain when rates fall.
  • The 10-year Treasury to cash spread turned negative, which may be a better indicator of whether recession has already struck.

Inflation vs. Interest Rates Over the Long Term

Federal Funds vs. Consumer Price Index

  • We are now looking at an inflation spike that is above the last rise in inflation from 2005–08.
  • The gap between inflation and the Fed Funds rate is larger than that seen just before the GFC.
    • Yield history suggests that the Fed Funds rate is typically above inflation, not below it.
  • Recent gaps between CPI and the Fed Funds rate are unprecedented in the history of the CPI-U, going back to 1955
    • Resolution to the historical relationship requires the Fed Funds rate to rise and inflation to fall.

10-Year Breakeven Rate: Bond Market Forecast of Inflation

10-Year Breakeven Inflation Rate

  • 10-year breakeven inflation rate is the difference in yield between the nominal 10-year Treasury and the 10-year Treasury Inflation-Protected Security (TIPS).
    • Extra yield nominal Treasury would have to earn to maintain the same purchasing power as a TIPS investment.
  • Values of implied inflation reached 3% in April but have since declined below 2.5%.
    • Includes current high levels of inflation.

Fixed Income

10-Year Expected Returns

Yield Curve Continued to Rise and Became Inverted in Second Half of 2022

Rising yields throughout 2022 brought capital losses across bond indices.

Higher yields would lead to higher future returns, especially if yields stay at elevated levels.

Treasury Yield Curve Change

Shape of Yield Curve at Different Points in Forecast Horizon

Our forecast has the yield curve steepening within the first few years.

With yields already high, we expect yields to reach equilibrium by year 10 of our forecast (vs. year 30 in prior forecasts).

Yield Curve Forecast

Spreads Dipped Through 2021 but Returned Toward Medians Throughout 2022

20 years ending 12/31/22

2022 projections had risk-free rates rising and credit spreads widening, creating twin headwinds for expected returns, especially for high yield.

After falling throughout 2021, credit spreads rose in 2022 and are closer to median in many cases.

Historical Option-Adjusted Spreads (OAS)

*Percentiles based on 20-year history of OAS for each respective index.

Duration for Intermediate and Longer-Dated Credit Still High but Fell Meaningfully

20 years ending 12/31/22

Duration for credit within the Agg is still high in historical terms but fell significantly in 2022.

  • The same is true for long credit.

The yield-to-duration ratio has improved across the maturity spectrum.

Historical Duration

Comparison of Core Fixed Income Return Components

Total Return Attribution: Callan 2023 Projection

Total Return Attribution: Callan 2022 Projection


U.S. Equity Market: Key Metrics

S&P 500 valuation measures

S&P 500 Index: Forward P/E Ratio

  • All valuation measures are now within +/- one standard deviation of 25-year averages.
  • Forward P/E is near the long-term average, but if we enter a recession both prices and earnings are likely to decline.

U.S. Equity Market: Return of Cash

S&P 500 yield broken down

Return of cash has risen in dollar terms and yields were further buoyed by declining share prices.

Equity Forecasts

Building blocks

U.S. Equity Assumptions

Mid and small cap relative valuations

  • Large capitalization stocks still have relatively high valuations.
  • Historically, smaller cap stocks have had higher valuations than large caps.
    • Investors buying future rather than historical earnings
  • The small cap S&P 600 P/E is only 71% of the S&P 500 P/E.
  • The mid cap S&P 400 P/E is only 75% of the S&P 500 P/E.
  • Lower valuations improve the potential for higher returns relative to large cap going forward.

S&P 600/S&P 500 Relative Forward P/E Ratios

S&P 400/S&P 500 Relative Forward P/E Ratios

Global ex-U.S. Equity Assumptions

Developed market valuations and dividend yield

Valuations have come down over the past year across each of these developed market indices.

  • U.S. continues to have the highest valuations.

Dividend yields have risen since last year for all indices shown except the U.K.

Global ex-U.S. Equity Assumptions

Emerging market valuations and dividend yield

Emerging market valuations have also come down over the last year, but moderately compared to developed market valuations.

  • Asia has the highest regional valuations, Emerging Europe the lowest.

Dividend yields have risen meaningfully across emerging market indices.

Significant dilution is realized as growing companies issue more shares.

Equity Forecasts

Risk premia over cash

Rolling 3-Year Excess Return Relative to 90-DayT-Bill for 40 Years Ended 12/31/22

Building block approach gives results consistent with an equity risk premium approach.

Alternatives: Focus on Real Estate and Private Credit

Core Real Estate

  • 5.75% core real estate compound return (net of fees)
  • Return calculations assume 4.7% cost of leverage and 0.4x debt-to-equity (30% loan-to-value)

Income Return 5.1%
(unlevered property)

Appreciation 0.7%
(unlevered property)

Total Return 5.8%
(before leverage)

Private Credit

  • Return calculations assume 5.25% cost of leverage and 1% unlevered loss ratio
  • Corresponds to 7% compound return
Unlevered Yield9.25%
Levered Yield12.65%
Mgmt Fee and OpEx1.7%
Incentive Rate15%
Incentive Fee1%
Total Fees and Exp.2.7%
Loss Ratio1.85%
Net Arithmetic8%

Loan Yields

Middle Market Premium

Detailed 2023 Expectations and Resulting Portfolio Returns and Risks

2023 vs. 2022 Risk and Returns Assumptions

Summary of Callan’s Long-Term Capital Markets Assumptions (2023–2032)

2023–2032 Callan Capital Markets Assumptions Correlations

7% Expected Returns Over Past 30 Years

2023 vs. 2022

Typical public DB

Higher risk and return improves nominal return by ~110 bps and increases risk by ~10 bps.

Real portfolio returns are higher in 2023.



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