AIMCo's 2021 Long-Term Asset Class Forecast

 AIMCo released its 2021 long-term asset class forecast:

AIMCo is anticipating a robust economic rebound in the next couple of years before growth rates settle back towards long-term trends. That’s the premise of the investment manager’s 2021 Long-Term Asset Class Forecast.

The forecast is prepared annually to help inform clients’ strategic asset allocation decisions and to establish reasonable expectations for risks and returns over a 10-year time frame. This year, AIMCo is sharing its analysis more widely, in the interest of transparency and with the idea it may be helpful to others as the world looks towards a post-pandemic recovery.

The long-term forecast covers 18 asset classes, including equities, fixed income and private assets. 

Take the time to download and read the entire document here

It was prepared by AIMCo's Economics & Fund Strategy Team, under the leadership of the CIO, Dale MacMaster, and its Chief Investment Strategy Officer (CISO), Amit Prakash.

Let me first thank Dénes Németh for sending me this document and congratulate him for being promoted to the position of Vice President, Corporate Communications & Public Affairs.

Anyway, I received this document late last week but took the weekend to read through it as it's not a quick read. 

I think it's worth posting the joint CIO and CISO message below:

Carefully devising strategic asset allocation assumptions is paramount to generate positive risk-adjusted outcomes for client portfolios. In this spirit, we are pleased to present the 2021 AIMCo Long-Term Asset Class Forecast. This exercise is a collaborative endeavour across AIMCo to construct a cohesive, long-term view to be used by our clients in their asset-liability discussions and actuarial deliberations. Long-term financial returns are underpinned by robust building blocks that are more stable than on shorter time investment horizons. These characteristics are supportive of long-term capital market assumptions as a reliable process to align clients’ long-term objectives and their long-term portfolio allocations. 

Certainly, from a short-term perspective, the COVID-19 pandemic has materially changed the world. Various economic sectors have been hit particularly hard, potentially requiring a restructuring in certain cases. Having learned some useful lessons during the Global Financial Crisis (GFC), policymakers across the globe reacted in an unprecedented and concerted manner to provide fiscal and monetary stimulus. They worked towards alleviating cash crunches for households and extended loans and bailouts thereby preventing going concern businesses from failing. In the footsteps of this unprecedented, whatever-it-takes stimulus approach, global markets have rebounded handsomely from the sharp drop of mid-March 2020.

Although the path could reveal itself to be a bumpy one, under the lens of a longer time horizon, the global economy is likely to recover. In the short-term, however, a rise in public spending has hit public finances similarly to past wars — government deficits have been pushed to levels not seen since the two world wars of the twentieth century. Furthermore, debt burdens have increased for many households and corporations, although the cost of debt has diminished due to lower interest rates. Optimistically, even with virus cases rising entering 2021, the advent of vaccines becoming more widely distributed could support a significant economic rebound accompanied by job growth, rising household and business incomes and expanding demand for goods and services. These elements should lead pressures on government finances to gradually abate and to a broader acceleration of prices and wages from depressed levels in the medium term. As such, we remain relatively constructive on the economic and market outlook over the next decade.

Many ongoing structural trends, such as an aging population in much of the developed world, are likely to continue slowing productivity growth. Such challenging economic trends are now compounded by the once-in-a-century shock induced by the pandemic, firmly leading to lower global trend growth onwards compared to what was experienced before the GFC. With monetary policy expected to be at the lower bound in terms of interest rates for the first few years of the next decade before tightening, financial conditions should remain supportive of risky markets, including equities and illiquid assets, such as real estate, infrastructure, private equity and renewable resources. 

In equity markets, however, valuations have rebounded post-March 2020 to rich levels in the footsteps of the consensus for moderate, albeit volatile, long-term economic growth. Furthermore, the increased focus on resolving social and economic inequalities from various governments might result in policies which could put upward pressure on wages, reversing past trends in high corporate margins. Combined with lower-trend economic growth, this points to more challenged equity returns over the next 10 years. In this scenario of gradually improving economic fortunes, bond yields are also expected to increase moderately over time. 

We look forward to discussing our long-term capital market assumptions with all clients and continuing the fruitful dialogue surrounding their impact on long-term portfolio construction. 

There's a lot of food for thought in this small comment, way more than I can properly cover here but I do suggest my readers look at my comments on why Canada's largest pension sees risk of inflation and my more recent comment on whether another commodities supercycle is upon us.

Importantly, there is tremendous fiscal and monetary stimulus, a normal response to the pandemic, but I remain very careful forecasting long term inflation trends.

As I keep warning my readers, don't confuse cyclical inflation pressures (from lower US dollar and rising oil prices) with secular inflation pressures that can only come from sustained wage gains.

Having said this, both inflation expectations and growth rates are positive and will put pressure on long bond yields.

Can US long bond yields back up more in the second half of the year? Yes, as the vaccine rollout goes smoothly there and across the developed world, we can see a pickup in US and OECD growth and this will put upward pressure on yields.

When will we reach pre-pandemic levels of growth? According to the nonpartisan Congressional Budget, the US jobs market will return to pre-pandemic levels in 2022:

U.S. economic growth will recover “rapidly” and the labor market will return to full strength more quickly than expected, thanks to the vaccine rollout and a barrage of legislation enacted in 2020, according to a government forecast published on Monday.

Gross domestic product, or GDP, is expected to reach its previous peak in mid-2021 and the labor force is forecast to return to its pre-pandemic level in 2022, the nonpartisan Congressional Budget Office said.

Importantly, the CBO said its rosier projections do not assume any new stimulus, including President Joe Biden’s $1.9 trillion stimulus plan.

Here’s what the CBO sees for the U.S. economy:

  • Real GDP to grow 3.7 percent in 2021
  • GDP growth to average 2.6 percent over the next five years
  • The unemployment rate to fall to 5.3 percent in 2021, and further to 4 percent between 2024 and 2025
  • Inflation to rise to 2 percent after 2023
  • The Federal Reserve to start hiking the federal funds rate in mid-2024
  • Upgrades the economic outlook through 2025

These projections are a stronger outlook than the budget office’s prior forecast from summer 2020, when the CBO said it expected the coronavirus to sap about $7.9 trillion of economic activity over the next decade-plus.

The CBO said it upgraded its estimates “because the downturn was not as severe as expected and because the first stage of the recovery took place sooner and was stronger than expected.” CBO staff added that businesses proved more able to adapt to government-imposed restrictions, but that certain industries — like hospitality and food services — are still struggling.

Regardless, the rapid expansion the CBO projects for the next five years is expected to moderate in the five years thereafter, amid an uptick in prices and a more normal level of long-term consumer spending.

Between 2026 and 2031, the CBO foresees real GDP growth of about 1.6 percent annually and the Fed allowing inflation to run above its 2 percent target.

The office also issued some analysis of the recent, $900 billion stimulus package that Congress passed in December. CBO estimates that the pandemic-related provisions in that legislation will add $774 billion to the deficit in fiscal year 2021 and $98 billion in 2022.

Those provisions will boost the level of real GDP by 1.5 percent, on average, in calendar years 2021 and 2022, CBO estimates.

The CBO’s outlook comes at a precarious time for the economy as the coronavirus prompts many states to impose business closures and other social-distancing measures to help slow the spread of the disease.

Economists say the economy suffered a brief, but sharp recession in 2020 as the unemployment rate spiked to 14.8 percent in April and growth contracted 31.4 percent in the second quarter. Covid-19 has killed more than 440,000 Americans, according to data compiled by Johns Hopkins University.

While the economy has come a long way since then, both Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell have in recent months warned that Congress may need to pass additional stimulus to support households and business until the Covid-19 vaccine is more widely available.

According to the latest reading, the U.S. employment rate stood at 6.7 percent in December. The Labor Department is scheduled to publish the next look at the employment situation this Friday.

Now, how high can US long bond yields go? Maybe we hit 2% on the 10-year Treasury note yield in 2022 and that's only if everything goes well all over the world and there's no negative shock in Europe or emerging markets.

Remember, as US growth picks up, the US dollar will rebound, placing pressure on some growth markets which have been on a tear over the last year.

If long bond yields all over the world remain negative or at record lows, it places pressure on US long bond yields, capping any backup in yields.

And even the CBO states inflation will rise to 2% after 2023, and I believe this is an optimistic forecast.

As far as the massive stimulus we are seeing -- both monetary and fiscal -- they were needed but are also causing massive distortions in wealth, exacerbating inequality, and that too constrains growth in the future.

All this stimulus, however, isn't leading to the economic recovery most have hoped, at least not yet. 

Still, it is occurring, all over the world, and bond markets are taking notice.

One thing that worries me a little is what happens if long term bond yields all over the world start rising way too fast. This will kill the recovery.

I don't think it will happen but markets tend to surprise you when you least expect it.

Anyway, enough of my thoughts, let's get to AIMCo's long term forecasts for each asset class:

As you can see, AIMCo's aggregate balanced fund is expected to achieve a 4.9% annualized return over the next decade.

The highest expected returns are in private markets -- Private Equity, Real Estate, Infrastructure and Renewable Resources -- all of which are expected to return between 6% (Canadian RE) and 10% (for PE). 

Of course, this led a cynical friend of mine to state "how convenient, private markets are where the highest returns are expected, where they can manipulate benchmarks to proclaim they added a lot of value over time."

But I submit, it's not just about private markets and fudging benchmarks, it's the approach in private markets that counts now more than ever at AIMCo and the rest of Canada's large pensions.

What do I mean? Take Private Equity and take two pensions allocating to PE, one solely through fund investments and the other other through funds and large co-investments.

Canada's large pensions take the second approach to reduce fee drag and to maintain their allocation to PE. It's not just economical, it's a superior approach in every sense but to do it properly, you need to hire talented people who are able to analyze co-investments quickly and diligently.

Anyway, back to AIMCo's long-term asset class forecasts. This year, AIMCo factored in climate change to its long-term forecasts:

I will let you read the details but it is an interesting analysis and climate change will impact all asset classes over the long run, negatively and positively.

Alright, let me wrap it up there, once again, please take the time to download and read AIMCo's 2021 Long-Term Asset Class Forecast here.

Every pension fund does this but at least AIMCo shares its analysis and results. It's an important exercise but it's not an easy one, a lot of things can and will happen over the next decade to change the final results (ie. the gap between expected returns and actual returns can be very wide if things go wrong).

Still, I encourage everyone to read the report to understand the building blocks of each asset class and how they come up with their expected return.

I applaud AIMCo’s Economics & Fund Strategy Team, Dale MacMaster and Amit Prakash for writing a thorough report with an excellent analysis as to how they derive their conclusions.

Below, Carl Weinberg, chief economist at High Frequency Economics, says inflation expectations are "unanchoring" from reality as a result of higher energy costs, arguing that true inflation in the US is a long way off.

And everyone knows Jeremy Grantham as the face of GMO, the behemoth money manager that has become legendary for its work on asset allocation, but Ben Inker, head of asset allocation at GMO since 1998, seems to be next in line for the throne. 

In this interview with Ed Harrison, Inker helps viewers make sense of the post-COVID investment landscape from the perspective of a major asset allocator. Together they discuss everything from the future of the 60/40 portfolio to bonds as an asset class in this new low rate world. They also dig in to US vs. non-US assets, the trouble with popular ex-post facto explanations for FAANG outperformance and narrative bubbles like Tesla, and why the financial sector can be so difficult to value. 

This interview was filmed on September 21, 2020. I wonder what he thinks nowadays.