Capital market updates: Adapting to economic shifts

We have updated our long-term capital market assumptions to reflect the current period of significant economic transition. We have moved from a time of ultra-accommodative monetary policy, persistently low inflation, and fiscal restraint to a period of conventional monetary policy, two-way inflation risks, and fiscal malfeasance. The changing environment demands that we re-test not only our existing assumptions and formulas, but also the approaches we take to asset allocation and portfolio construction.

Our forecasts for a ‘balanced portfolio’ (+6.8%) are fractionally lower than last year, largely thanks to more conservative equity and credit assumptions following a strong period of performance. We have upgraded our US growth (+2.2%) and cash rate (+3.5%) assumptions to reflect the ongoing resilience of the US economy in the face of restrictive monetary policy, as well as growing bipartisan support from both sides of government to run large fiscal deficits in support of long-term strategic initiatives.

US Dollar Strength

Citi Broad Effective Exchange Rate (REER)

We also upgraded our European (+2.3%) and Japanese (+1.8%) inflation forecasts in response to growing evidence of entrenched wage inflation. In contrast, our Chinese growth (+3.9%) forecasts are lower to reflect the structural headwinds (property supplydemand imbalance, ageing population, geopolitical tensions) buttressing the world’s second-largest economy. Naturally, this has flow-on effects for key trading partners such as Europe and Australia though we remain cognisant that the policy direction in China remains subject to change.

We have also considered a range of alternative economic scenarios that present both upside and downside risks to our forecasts, namely:

• An artificial-intelligence linked boom which would boost developed market GDP by 1.0%- 3.0% over a 10-year horizon. We interpret that developed market equities such as the US would likely be the largest beneficiaries given greater scope for automation and more advanced R&D programs.
• Persistent inflation volatility as structural forces such as the energy transition, deglobalisation and ageing demographics create demandsupply\ imbalances. We would expect this scenario to trigger shorter and sharper economic cycles and higher risk premiums in assets such as equities and credit.
• A period of sustained US Dollar devaluation as the Euro and Yen exit negative interest rate regimes and the US Government’s fiscal position continues to deteriorate. This could prompt capital flight from USD denominated investments and act as a headwind to any offshore unhedged investments for Australian investors.

Risk & Reward: Sub-Asset Classes

Forecast total return and volatility assumptions

The implications for portfolios should not be understated. Inflation risk is now two-way, meaning investors must have reasonable allocations to both defensive and risk assets as a means of hedging against recession and generating positive real returns. While we remain confident that the global economy can gradually glide to a soft landing, we remain cognisant that economies are fragile and policy missteps could prompt an inflation overshoot or trigger
recession.

We think alternative assets such as private credit, private equity and unlisted infrastructure can play a pivotal role here, as these assets have a proven track record of delivering risk-adjusted returns whilst also contributing valuable diversification benefits through lowly correlated returns. We continue to advocate for our clients to build on current allocations, noting the investment universe is becoming increasingly accessible to wholesale and retail investors via innovative and fee efficient vehicles.