Capital market forecasts

Last updated November 20262 sectionsabout 12 min read

Every asset allocation decision in this guide, from the chapter on asset allocation onward, starts from an assumption about future asset class returns, risks and correlations. This short opening chapter covers how those capital market expectations are actually formed.

The forecasting framework

• Specify the forecast's purpose, horizon and the specific asset classes needed (echoing the planning step of the portfolio management process in CIFA Portfolio Management)
• Research the historical record and the current environment for each asset class
• Select and apply appropriate forecasting tools (see Forecasting asset class returns, below)
• Formulate the forecast, and document its assumptions and limitations for later review
• Monitor actual outcomes against the forecast and refine methodology over time

Role and challenges of forecasting

Capital market expectations sit between the client's objectives and the portfolio itself. The investment policy statement says what the client needs; the forecast says what each asset class is likely to deliver; strategic asset allocation is the point where the two meet. Get the forecast badly wrong and every allocation decision built on it is wrong too, however sound the process that follows.

Forecasting is hard for reasons that are structural rather than a matter of effort:

• Poor quality or short data histories, which is acute in frontier and emerging markets where a series may not span a full cycle
• Regime change: a relationship estimated under one monetary or exchange rate regime need not survive into the next
• Non-stationarity and small sample bias, so a long average conceals two different periods rather than describing either
• Behavioural bias in the forecaster: anchoring on the recent past, overconfidence in a narrow range, and herding towards the consensus
• Model uncertainty, where the choice of model drives the answer as much as the data does

Exogenous shocks are the sharpest version of the problem: a pandemic, a war, a sudden commodity price move or an abrupt policy change alters the growth path itself rather than moving the economy along it. Because they are by definition outside the model, no forecasting technique anticipates them. The practical response is not to predict them but to build allocations robust to them, and to state the forecast's assumptions explicitly so that a broken assumption is visible when the shock arrives.

Growth, cycles and inflation

Long-run trend growth, driven by labour force growth, capital accumulation and productivity, anchors the long-horizon forecast, because over decades asset returns cannot detach from the growth of the economy generating them. The business cycle drives the short horizon. Distinguishing the two is the single most useful discipline in this section: a cyclical downturn is not a change in trend growth, and treating it as one produces a permanently pessimistic forecast.

Approaches to economic forecasting fall into three families:

• Econometric modelling: a system of estimated equations, rigorous and internally consistent, but only as good as its specification and slow to reflect structural change
• Leading indicators: variables that reliably turn before the economy does, simple and timely, but prone to false signals
• Checklist assessment: a structured judgemental review of the main drivers, flexible and able to incorporate the unmodellable, but subjective and hard to replicate

Inflation moves with the cycle, and each asset class responds differently. Rising inflation late in an expansion pushes central banks to tighten, which lifts cash returns, hurts bonds directly through higher yields, compresses equity valuations while nominal earnings may still rise, and tends to support real estate, whose rents and capital values are contractually or economically linked to the price level. Disinflation in a slowdown reverses the pattern and is the classic environment for bonds to outperform.

Policy and international linkages

Monetary policy acts on the cycle through interest rates and the supply of credit, and fiscal policy through taxation and government spending. Their combination matters more than either alone: loose fiscal policy against tight monetary policy tends to raise real interest rates and strengthen the currency, while the reverse combination tends to weaken it. That is the standard reasoning an exam answer is expected to reproduce.

Economies are linked through three channels the forecaster must trace:

• Macroeconomic linkage through trade, so a slowdown in a major trading partner transmits directly into export demand
• Interest rate linkage through capital flows, since capital moves towards the higher risk-adjusted real return and drags domestic rates with it
• Exchange rate linkage, which transmits the other two into import prices, inflation and the local-currency return an international investor actually earns

Forecasting asset class returns

Fixed income and emerging markets

A fixed-income return forecast is built rather than averaged. Start from the yield to maturity, add the roll-down return earned as the bond ages along an upward-sloping curve, add or subtract the expected capital movement from the forecast change in yields, and deduct expected credit losses, that is, probability of default multiplied by loss given default.

Emerging market debt carries risks that a developed market forecast does not have to price. The most important is that the sovereign is often the reference credit for the whole market, so sovereign stress and corporate stress arrive together rather than diversifying each other.

• Sovereign default and restructuring risk, and the weaker legal recourse a creditor has against a sovereign
• Currency risk, where a local-currency bond can deliver a solid domestic return and a substantial loss once converted
• Political and policy instability, including capital controls imposed precisely when an investor wishes to exit
• Thin liquidity, so exit is most expensive exactly when it is most wanted

Country risk analysis is conventionally organised around six questions:

• Fiscal position: is the deficit and the debt-to-GDP path sustainable, and what share of revenue goes to interest
• External position: current account balance, external debt, and reserve cover measured in months of imports
• Monetary and inflation record, and whether the central bank is genuinely independent
• Growth prospects and how concentrated the economy is in a single commodity or sector
• Institutional quality: rule of law, contract enforcement, and the record on honouring obligations
• Political stability, and the record of policy continuity across changes of government

Real estate forecasts

Real estate is forecast from its own drivers rather than from equity market expectations. Demand comes from economic and demographic factors: employment growth for offices, household formation and urbanisation for residential, consumer spending for retail, and trade volumes for industrial and logistics space.

Supply is the competitive factor, and it is what distinguishes real estate from most asset classes. Construction takes years, so new supply arrives in response to yesterday's rents and often lands just as demand turns, which is why property cycles are longer and more pronounced than the general business cycle. A sector forecast therefore has to look at the development pipeline, not only at current vacancy. Capitalisation rates move inversely with property values and tend to follow long bond yields, so the interest rate forecast made for fixed income feeds directly into the real estate forecast.

From forecast to portfolio weights

Once the forecast is formed, it must show up in weights or it has changed nothing:

• Expected trend growth revised upwards in a region argues for raising equity weight there.
• A widening real interest rate differential argues for currency and fixed income adjustments.
• A deteriorating fiscal position argues for reducing exposure to that sovereign's debt.

The discipline is to move weights for a stated change in expectations, and to record the reasoning, so that a later review can distinguish a forecast that was wrong from an allocation that failed to follow the forecast.