Aon Hewitt
Consulting | Investment Consulting Practice
Capital Market Assumptions
As of 31 December 2016
Risk. Reinsurance. Human Resources.
2
Capital Market Assumptions
Table of contents
Inflation – more uncertainty?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Inflation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Fixed income government bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Inflation-linked government bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Investment grade corporate bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
US high yield debt and emerging market debt . . . . . . . . . . . . . . . . . . . 11
Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Private equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Hedge funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Correlations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Capital Market Assumptions methodology . . . . . . . . . . . . . . . . . . . . . . . 18
Contacts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Aon Hewitt 3
Inflation – more uncertainty?
Expected inflation is a set of key numbers in our capital market
Whatever the merits behind an inflation ‘regime change’
assumptions, arguably some of the most important. On a
argument, we do agree that there is a fair degree of
standalone basis, inflation’s importance as a core economic
uncertainty on the inflation outlook, arguably more than we
and investment variable hardly needs restating. Within our
would deem normal. Inflation assumptions therefore need
capital market assumptions process, its importance also
particular care.
comes from its role as a key driver of many of our asset
class assumptions. It should be apparent that inflation is a
Our approach: A ‘filtered consensus’ on inflation
key part of the expected return for holders of index-linked
Our approach to formulating inflation assumptions for the
gilts in the UK or TIPS in the US especially given very low
past decade has been to derive a filtered consensus. This is
or negative yields on inflation-linked bonds. Elsewhere, our
done by giving a careful consideration of informed views from
equity return assumptions feature inflation as a key driver of
as wide a variety of sources as possible. We use think tanks
return variability, given the assumption that equities will be
and research institutes, central bank projections, ‘buyside’
‘inflation neutral’ over time (even though we acknowledge
and ‘sellside’ forecasts. Alongside, we do research in house
that the veracity of this assumption may not hold if inflation is
on the longer-term inflation outlook, but our philosophy on
sustained at either very high or very low levels over time). Yet
setting the inflation assumption is, much like it is over our
another example is commercial property, where our estimates
capital market assumptions process as a whole, to adopt a
for growth in rents are tied to inflation.
view that seems to be representative of a central expectation
Is an inflation ‘regime change’ on its way?
At this time, the importance of the inflation input into our
assumptions process is particularly important. This is because
there is greater than usual uncertainty being ascribed to
the inflation outlook. These arguments are along the lines
of growing risk of a ‘regime change’ – a move from the
moderate inflation environment that has held more or less for
the last three decades to something different. Opinions are
divided among regime change proponents, with some fearing
a break to the upside, but a vocal minority continue to fear a
move to the downside.
Our focus in the capital market assumptions is on the longer-
to avoid any strong selection bias in the numbers.
The research that is done by us helps us filter the views in
an appropriate way, allowing us to reject those projections
and forecasts from consideration which seem to have weak
analytical and empirical foundations. The objective of
deriving an informed consensus view is then much more
likely to be met. It takes time to complete this filtering process
every quarter, but it is a worthwhile endeavour given its
importance. We regard this process as having adequate
capacity to handle any additional current uncertainty over the
inflation outlook such as that which we see now.
arguments for a changed outlook do not, on a closer look,
Why break-even inflation is an unreliable
estimator of expected inflation
appear to be very significant drivers of the outlook over
Some may question this degree of effort, pointing out that the
term inflation outlook of 10 years or more. Some of these
these time horizons. Many of those who are arguing that
inflation will rise markedly turn out to be making a prediction
for the next 2 or 3 years rather than for the longer period
we are more interested in. For example, weak sterling is
cited as inflationary, but this is largely a temporary rise in
the price level. A one-off stimulus to the US economy is also
not tantamount to a sustained rise in inflation. There are
those who are more explicitly arguing for a global ‘regime
change’ view. However, there has to date been no satisfactory
narrative or path to show why, how and when a move to
much higher sustained inflation would result, and much the
same goes for a move down towards deflation.
4
among as wide a group of investors/stakeholders as possible
Capital Market Assumptions
bond market’s pricing of long term inflation is a sufficiently
good estimator. One advantage is that the market pricing
exists in ‘real time’, whereas our approach relies on forecasts
and projections which appear at discrete intervals and need
adjustments to compare on a like for like basis. It seems all the
more obvious given that the inflation-linked bond market is
where the ‘price’ reflects the weight of money as investors
take positions as they hedge their inflation risk (or not).
Yet, it is for this very reason that break-even inflation, more
A priori, some difference should be seen between the two,
often than not, does not reflect inflation expectations
reflecting an inflation risk premium which compensates
particularly well, especially at any given point in time.
investors for inflation risk and liquidity issues in inflation-
Inflation pricing in bond markets is merely the difference in
linked markets. The very fact that inflation hedging is a more
yields (of equivalent duration) between fixed interest bonds
important consideration for investors in inflation-linked
and those which are indexed for inflation. However, the
markets relative to fixed interest bonds is already sufficient
markets in fixed interest bonds and those in inflation-linked
to make a difference in terms of inflation price sensitivity
bonds are usually quite segmented. Fixed interest markets are
between the two groups of investors.
typically far larger, more liquid, and attract more international
investors. By contrast, inflation-linked markets are not as
liquid, typically of longer duration and attract different groups
of investors. Inflation hedgers like pension funds typically
In the UK, the inflation risk premium tends to be higher than
in other regions, reflecting a demand-supply imbalance
in the inflation-linked market. UK regulation is particularly
strict on inflation indexation of pension liabilities creating
play a much larger role. This makes it difficult to take the
substantial demand (realised and pent-up for inflation linked
difference in yields between the two markets at any given
point in time as a reliable estimate of consensus expectations
bonds) relative to supply. As a result, we find that inflation
of long duration inflation.
break-evens generally always exceed expected inflation by
In comparing our inflation expectations with inflation pricing
substantially, most recently last summer (see chart below).
a sizable margin, even though this has sometimes narrowed
in bond markets, we find that, some quite large differences
regularly arise between what we regard to be a best estimate
of broad inflation expectations and that coming from the
bond market.
Historical UK break-even inflation vs Filtered consensus inflation expectations
Q 20 year duration break-even inflation Q Consensus 20 year inflation expectations
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Source: Bloomberg, Consensus Economics, Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
Aon Hewitt 5
By contrast, in the US, where inflation linked bonds
Canada appears as an intermediate case between the US
are less sought after by pension funds and other
and the UK. Here, break-even inflation rates are generally
institutional investors, the premium that inflation
above expected inflation, and even though a similar position
hedgers are normally willing to pay is rather smaller and
to the US has been seen in recent years where the premium
in recent years has been very low or even negative1.
has shrunk substantially, it is not as pronounced as the US.
Historical US break-even inflation vs Filtered consensus inflation expectations
Q 20 year duration break-even inflation Q Consensus 20 year inflation expectations
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Source: Bloomberg, Consensus Economics, Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
The key point, however, is that that there are sustained
Even so, the process of convergence with the estimated
deviations in bond market pricing from best estimates of
move in inflation expectations can take time, and is subject
long-term inflation everywhere. This is not that surprising.
to sudden market moves as they react to bond-sensitive
Large moves in yields at important turning points tend to
news-flow. This makes break-even inflation a great deal more
begin in fixed interest markets given their greater liquidity
variable than actual changes in inflation expectations.
and sensitivity to day to day interest rate-sensitive news
developments. If inflation-linked markets are less sensitive,
break-even inflation will typically lead the move. This gives
the appearance of a move in inflation expectations, even
Much like central banks, we do think that persistent trends
in break-even inflation are communicating a message on the
trend, if not the level, of underlying inflation expectations.
though it is not really reflective of that at all.
Unfortunately, even though there is some information to be
Over time, however, there is a process of inflation-linked
expected inflation at particular points in time.
gathered from these moves in this way, it does not help us set
markets converging towards inflation expectations. This
means that break-even inflation will work better as an
indicator of expected inflation taking say an average over a
period of time rather than at a point in time.
Has the inflation risk premium fallen and is it now negative? Andrew Chen, Eric Engstrom, Oleya Grishenko, US Federal Reserve notes, April 2016
1
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Capital Market Assumptions
What are our inflation assumptions and breakeven inflation telling us about the outlook?
Our filtered consensus approach is not signalling a regime
shift in inflation at this time. In the UK, US and the Eurozone,
we do have higher inflation estimates for the next two or
three years, reflecting a variety of factors, but this is not
as yet translating to very much change in the longer-term
assumption. Our current 10 year UK RPI assumption is
currently not far from the middle of the range seen since
2012 (see chart above) even after allowing for the rise
expected in 2017-18.
In the US, near-term upward revisions have similarly fed
through into a slight tick up in the long-term assumption,
which has risen about 0.2% from its low point a year ago, but
this is within the normal magnitude of fluctuation so we do
not read much into it.
Market forecasters – investment banks, asset managers,
economic research institutes and even central banks like
the Bank of England warn of higher uncertainty in their
projections. However, this is not translating into much higher
or lower longer-term projections, with only a small number
of exceptions.
As it happens, much the same is true if we assess what
underlying trends in break-even inflation are telling us. If we
take the past year as a whole, the message is not inconsistent
with the profile of our inflation assumptions. There was
something of a dip in the 2015/16 period in our long-term
inflation assumptions. Break-even inflation rates temporarily
overshot on the downside at the time. In recent months,
these market inflation rates have been moving up sharply,
correcting that anomaly. It is possible looking ahead now that
they overshoot on the upside, though this does not appear to
have yet happened in the US case.
Through this period of volatile break-even inflation,
underlying inflation estimates have stayed within a range that
can be very well described as ‘moderate inflation’ or inflation
that is well ‘anchored’. If a major inflection point is indeed
coming in long-term inflation, that expectation is not being
signalled anywhere as yet.
Aon Hewitt 7
Inflation
USD
GBP
EUR
CHF
CAD
JPY
CPI Inflation (10yr assumption)
2.2%
2.1%
1.6%
1.1%
2.0%
1.1%
RPI Inflation (10yr assumption)
-
3.2%
-
-
-
-
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
Realised inflation has been rising on a global basis whilst
firmer outlook for commodities over the next few years
supports higher inflation expectations. Whilst our near term
expectations for both UK CPI and RPI inflation has risen on
the back of sterling weakness, the longer term assumption
is unchanged.
Similarly, longer term assumptions for Switzerland, Canada
and Japan are unchanged relative to the last quarter. However,
the anticipated shift in economic policy under the new US
administration alongside a firmer outlook for commodity
prices has driven US CPI inflation modestly higher to 2.2%.
On a 10 year horizon, this has pushed US inflation further
away from the US Federal Reserve’s 2% target level. The 10
year inflation assumption has also been revised slightly higher
for Europe, these represent the only changes in inflation
assumptions across the regions covered in the Capital Market
Assumptions, and Europe and especially Japan remain a fair
distance away from their respective central bank targets.
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Capital Market Assumptions
Fixed income government bonds
10yr Annualised Nominal Return Assumptions
US
UK
Eurozone
Switzerland
Canada
Japan
USD
GBP
EUR
CHF
CAD
JPY
5yr
2.5%
2.4%
1.9%
1.3%
2.3%
1.4%
15yr
3.1%
3.0%
2.6%
2.0%
3.0%
2.1%
5yr
1.3%
1.2%
0.7%
0.2%
1.1%
0.2%
15yr
1.7%
1.6%
1.1%
0.6%
1.5%
0.6%
5yr
1.1%
1.0%
0.5%
0.0%
0.9%
0.0%
15yr
1.9%
1.8%
1.3%
0.8%
1.7%
0.8%
5yr
0.9%
0.8%
0.3%
-0.2%
0.7%
-0.2%
15yr
1.6%
1.5%
1.0%
0.5%
1.4%
0.5%
5yr
1.8%
1.7%
1.2%
0.7%
1.6%
0.7%
15yr
2.8%
2.7%
2.2%
1.6%
2.6%
1.7%
5yr
1.0%
0.9%
0.5%
-0.1%
0.9%
0.0%
15yr
1.4%
1.3%
0.9%
0.3%
1.3%
0.4%
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information. In our assumptions we take French bonds to represent Eurozone bonds.
Strong nominal government bond yield rises over the
In our assumptions we take French bonds to represent Eurozone
quarter to 31 December 2016 led to increases in all nominal
bonds, as we want to ensure consistency between the nominal
government bond returns that are considered in the Capital
and inflation-linked government bond returns and there is a
Market Assumptions.
reasonably liquid market in French inflation-linked bonds. Our
US fixed income return assumptions have risen the most,
reflecting the larger increases in yields relative to other
regions. Greater expectations of rising short term interest rates
alongside a slight widening in risk premiums at longer durations
particularly after the US Presidential election are attributed
to most of this increase. From a UK perspective, sterling
calculation of a weighted average Eurozone government bond
yield leads to a figure which is slightly higher than the yield on
French government bonds. Our analysis therefore supports the
use of French bonds as a proxy for Eurozone bond portfolios,
where these portfolios do not have a large exposure to the
higher yielding periphery.
weakness has boosted inflation expectations for the next few
years whilst the expected interest rate path from the Bank of
England has risen from the prolonged zero-rate path that was
initially expected in the aftermath of the Brexit decision. The
movement in yields over the quarter has brought yields back
to where they were at the start of 2016. Similar to the UK, mild
upward adjustments in expected policy interest rates over the
next several years has pushed European bond yields higher.
Strengthening economic activity as well as firmer commodity
prices provided additional upward thrust in yield movements.
Meanwhile, yield curve control and government bond
purchases by the Bank of Japan kept Japanese government
bond yields from mirroring the magnitude of the increases
seen in other developed markets.
Aon Hewitt 9
Inflation-linked government bonds
10yr Annualised Nominal Return Assumptions
US
UK
Eurozone
Canada
USD
GBP
EUR
CHF
CAD
JPY
5yr
2.9%
2.8%
2.3%
1.8%
2.7%
1.8%
10yr
2.9%
2.8%
2.3%
1.8%
2.7%
1.8%
5yr
1.3%
1.2%
0.7%
0.2%
1.1%
0.2%
15yr
0.8%
0.7%
0.3%
-0.3%
0.7%
-0.2%
5yr
1.6%
1.5%
1.0%
0.5%
1.4%
0.5%
10 yr
1.5%
1.4%
1.0%
0.4%
1.4%
0.4%
5yr
-
-
-
-
-
-
15yr
2.2%
2.1%
1.7%
1.1%
2.1%
1.1%
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information. In our assumptions we take French bonds to represent Eurozone bonds.
Similar to their nominal counterparts, the return assumptions
We formulate return assumptions for 10 year US and
for index-linked government bonds increased across the
Eurozone inflation-linked government bonds rather than
board. This was driven by higher real yields as well as
15 year bonds. This is because we think that the absence
upward adjustments to inflation expectations. Relative
of inflation-linked bonds at the longest durations in these
to other regions, US index-linked government bond
markets can lead to misleading 15 year bond return
returns increased the most as real yields and inflation
assumptions. We no longer publish a 5 year duration
assumptions rose the most. The UK return assumptions, on
Canadian inflation-linked government bond assumption
the other hand, rose the least as the increase was primarily
due to the lack of short duration bonds in this market.
driven by higher near term inflation expectations.
We have taken French bonds to represent Eurozone
bonds, partly because there is a reasonably liquid market
in French inflation-linked bonds. Our analysis of nominal
government bonds also suggests that French bonds are
a reasonable proxy for Eurozone government bonds so
we make the same assumption here for consistency. The
bonds represented are linked to Eurozone inflation.
10
Capital Market Assumptions
Investment grade corporate bonds
10yr Annualised Nominal Return Assumptions
US
UK
Eurozone
Switzerland
Canada
Japan
USD
GBP
EUR
CHF
CAD
JPY
5yr
3.3%
3.2%
2.7%
2.1%
3.1%
2.2%
10yr
4.0%
3.9%
3.4%
2.8%
3.8%
2.9%
5yr
2.2%
2.1%
1.6%
1.0%
2.0%
1.1%
10yr
2.4%
2.3%
1.8%
1.2%
2.2%
1.3%
5yr
1.4%
1.3%
0.9%
0.3%
1.3%
0.4%
10yr
1.8%
1.7%
1.2%
0.6%
1.6%
0.7%
5yr
1.3%
1.2%
0.7%
0.2%
1.1%
0.2%
10yr
1.5%
1.4%
1.0%
0.4%
1.4%
0.5%
5yr
3.0%
2.9%
2.4%
1.8%
2.8%
1.9%
10yr
3.8%
3.7%
3.2%
2.6%
3.6%
2.7%
5yr
1.3%
1.2%
0.7%
0.1%
1.1%
0.2%
10yr
1.4%
1.3%
0.8%
0.3%
1.2%
0.3%
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
Corporate bond returns depend on both a government
The reduced scope for spread reversion is however more
yield component and a credit spread component but also
than offset by increases in government bond yields. Similar
take account of losses arising from defaults and bonds being
to other local currency fixed income markets, US corporate
downgraded. The lead article to the 30 June 2015 Capital
bond return expectations rose the most, which reflected
Market Assumptions publication discusses these two potential
the strong rise in US treasury yields over the quarter. A
drivers of credit losses in more detail.
similar albeit weaker trend relative to the US, was followed
The corporate bond return assumptions have increased over
the quarter. This was despite a narrowing of credit spreads
by UK, Canadian, Japanese and European investment grade
corporate bonds.
across almost all regions.
US high yield debt and emerging market debt
US high yield debt spreads tightened significantly through
The lead article to the 31 December 2015 Capital Market
the fourth quarter as risk appetite was generally buoyant.
Assumptions publication discusses the High Yield assumption
Despite the relatively low duration of these bonds, interest
in more detail.
rate trends were such that yields still moved sufficiently
high enough to offset the reduction in expected returns
from narrowing credit spreads. Overall the assumption has
been adjusted upwards by 0.2% to 4.3% per annum over
the next 10 years. It is worth noting that our high yield debt
assumption already incorporates an expectation that defaults
will be consistently higher in future than the very low levels
Our return assumption for USD-denominated emerging
market debt (“EMD”) is 4.5% a year for the next 10 years.
Like high yield, the assumption moved higher mostly due
to the rise in yields on the underlying government bond
component whilst a slight widening of credit spreads
provided additional support.
seen over recent years.
Aon Hewitt 11
Equities
10yr Annualised Nominal Return Assumptions
USD
GBP
EUR
CHF
CAD
JPY
US
6.4%
6.3%
5.8%
5.2%
6.2%
5.3%
UK
6.6%
6.5%
6.0%
5.4%
6.4%
5.5%
Europe ex UK
6.9%
6.8%
6.3%
5.7%
6.7%
5.7%
Switzerland
6.6%
6.5%
6.0%
5.4%
6.4%
5.5%
Canada
6.8%
6.7%
6.2%
5.6%
6.6%
5.7%
Japan
6.3%
6.2%
5.7%
5.1%
6.1%
5.2%
Emerging Markets
7.7%
7.6%
7.1%
6.5%
7.5%
6.6%
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
Our equity return assumptions are driven by current
The earnings growth component of our equity return
market valuations, earnings growth expectations and
assumptions comprises both near term and longer term
assumed payouts to investors. The price you pay is one
elements. While our Capital Market Assumptions process
of the biggest drivers of returns, even over the long
typically involves using consensus inputs, for some time we
term. Looking back over recent experience, strong equity
have believed that the consensus of analysts’ forecasts has
market performance has been driven more by increasing
been unrealistically optimistic regarding near term earnings
valuations than increasing profits. With the exception of
growth prospects. Unlike analysts, against a backdrop of
Japanese equities, expensive valuations have been broadly
weak global growth, we do not expect company profit
offset by upward revisions in corporate earnings growth.
margins to increase from their already elevated levels. For
Modest increases in earnings growth expectations in Japan
were unable to mitigate stretched valuations and as such the
return assumption has decreased by 0.4%. UK assumptions
increased the most by 0.3% this quarter as sterling weakness
and stronger energy prices provided a boost to earnings
growth expectations. Despite upward revisions in earnings
earnings paths which have led to lower growth assumptions
than forecast by the consensus. Not being influenced by
short-term market sentiment, our near term earnings growth
assumptions have been relatively stable overall, in contrast
to consensus expectations, which have varied far more.
growth and inflation assumptions for US equities, the strong
In the long term, we assume that companies’ earnings
market appreciation during the fourth quarter limited the
growth is related to GDP growth. Crucially, we do not
increase in the overall return assumption to only 0.1%.
assume a one-to-one relationship between a country’s
Return assumptions remain fairly close between the
US, UK and Europe. UK equities were trading on
a multiple of around 17.2 times our 2016 earnings
assumption, while US equities were valued at around
18.4 times our 2016 earnings assumption.
Our emerging market equities return assumption has risen
from last quarter, primarily due to lower valuations that
were a consequence of significant capital outflows following
the US Presidential election. A pick up in our inflation
assumptions for the region also contributed to an increase
in the nominal return assumption over the 10 year period.
12
this reason, we have developed our own in-house corporate
Capital Market Assumptions
growth rate and the long term earnings growth potential of
companies listed on the stock market within that country.
We do this because many companies are international in
nature and derive earnings from regions outside of where
they have a stock market listing. An implication is that
European company earnings have only about a 50% direct
exposure to developments in the Eurozone and similarly,
investors in non-European equity markets should not
consider themselves insulated from events there either.
It is also notable that emerging markets are an important
driver of profits earned in the developed world.
Private equity
We assume that global private equity will return 8.5%
per annum over the next 10 years in US dollar terms. The
assumption represents a diversified private equity portfolio
with allocations to leveraged buyouts (LBOs), venture capital,
mezzanine and distressed investments. Return expectations
for these different strategies depend on different market
factors. For example, distressed investments are influenced
by the outlook for high yield debt so receive a boost from
higher return expectations in this area. Similarly, LBO
returns are influenced by the outlook for equity markets as
well as the cost of the debt used to finance these LBOs.
Notwithstanding this, whereas in the past leverage has
been a big driver of private equity returns, particularly for
LBOs, in future the ability of managers to add value through
operational improvements will become more important.
On our analysis, the median private equity fund manager has
historically performed in line with the median public equity
manager, but high performing private equity managers have
performed significantly better. Our assumption incorporates
the level of manager skill (‘alpha’) associated with such a high
performing manager. This contrasts with our other equity
return assumptions where no manager alpha is assumed.
Aon Hewitt 13
Real estate
10yr Annualised Nominal Return Assumptions
USD
GBP
EUR
CHF
CAD
JPY
US
5.4%
5.3%
4.8%
4.2%
5.2%
4.3%
UK
5.5%
5.4%
5.0%
4.4%
5.4%
4.4%
Europe ex UK
6.1%
6.0%
5.5%
4.9%
5.9%
5.0%
Canadian
5.1%
5.0%
4.5%
3.9%
4.9%
4.0%
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
The theme of expensive valuations remains across the
in Europe were only able to partially offset lower rental yields
regions and this has put downward pressure on most of
and the 0.4% fall in European property now brings the market
our real estate assumptions compared with 12 months
more in line with the real estate return assumptions for all
ago. However, regional markets have continued on
the markets covered in our Capital Market Assumptions.
their divergent trend from the previous quarter.
capable of investing directly in real estate. The assumptions
higher near term inflation expectations as well as a small
relate to the broad real estate market in each region rather
adjustment to rental yield expectations. This builds upon
than any particular market segment. Our analysis allows
a similar increase from the previous quarter’s assumption.
for the fact that real estate is an illiquid asset class and
However, these two consecutive upward revisions have yet
revaluations can be infrequent, leading to lags in valuations
to fully pare back the 0.6% fall in assumptions from earlier
compared with trends in underlying market value. These
in 2016, where concerns over the impact of Brexit on capital
assumptions do not include any allowance for active
values and rental growth weighed on return expectations.
management alpha but do include an allowance for the
The US assumption is unchanged from the previous quarter.
unavoidable costs associated with investing in a real estate
European and Canadian assumptions are lowered due to a
portfolio. These include real estate management costs,
decline in rental yields, as well as deterioration in the outlook
trading costs and investment management expenses.
for rental growth in the latter. Higher inflation expectations
14
Our assumptions here are in respect of a large fund which is
The UK assumption increased by a further 0.1% driven by
Capital Market Assumptions
Hedge funds
Our fund of hedge funds return assumption has been
Given the nature of the asset class, our hedge fund return
increased to 3.8% a year in US dollar terms. We formulate
assumptions are more stable than, for example, our US equity
this by combining the return assumptions for a number of
return assumption. Nonetheless, the strategies are impacted
representative hedge fund strategies. As with private equity,
by changes to the other asset class assumptions. For example,
this assumption includes allowances for manager skill
most hedge funds are ‘cash+’ type investments to a greater
and related fees (including the extra layer of fees at the
or lesser extent, so changes in return expectations for cash
fund of funds level), but unlike private equity, this is for
will contribute to hedge fund assumptions. Similarly, changes
the average fund of funds in the hedge fund universe
to our equity and high yield return assumptions influence
rather than for a high performing manager. Dispersion
expected returns for those strategies which are related to
in returns is high and we expect top quartile managers
these markets, such as equity long-short and distressed debt.
to deliver considerably better performance.
As set out in the lead article to 30 September 2015
Capital Market Assumptions publication, our analysis
allows for the fact that hedge fund managers have been
unable to deliver the high levels of ‘alpha’ that they
did in the more distant past and that alpha generation
is likely to remain challenging moving forwards.
The individual hedge fund strategies we model as
components of our fund of hedge funds’ assumption are
equity long/short, equity market neutral, fixed income
arbitrage, event driven, distressed debt, global macro and
managed futures. Our modelling of these strategies includes an
analysis of the underlying building blocks of these strategies.
For example, we take into account the fact that equity long/
short funds are sensitive to equity market movements. In
practice the sensitivity of equity long/short funds to equity
markets can vary substantially by fund with some behaving
almost like substitutes for long only equity managers, while
others retain a much lower exposure. Our assumptions are
based on our assessment of the average sensitivity across
the entire universe of equity long/short managers.
Aon Hewitt 15
Volatility
9.0%
15yr Fixed Income Government Bonds
11.0%
10yr Investment Grade Corporate Bonds
9.0%
Property / Real Estate
12.5%
years overall. For illiquid asset classes, such as real estate,
US High Yield
12.0%
de-smoothing techniques are employed. All volatilities
Emerging Market Debt (USD denominated)
13.0%
UK Equities
19.0%
US Equities
17.0%
Europe ex UK Equities
19.0%
Please note that due to the level of yields and shapes
Japan Equities
20.0%
of the yield curves in Japan and Switzerland, lower
Canada Equities
19.0%
Switzerland Equities
19.0%
Emerging Market Equities
30.0%
becomes more limited and this limits volatility – although
Global Private Equity
25.0%
clearly the risk of upward moves remains high.
Global Fund of Hedge Funds
9.0%
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
16
History, forward looking indicators and our view on
15yr Inflation-Linked Government Bonds
Capital Market Assumptions
the economic cycle all enter our volatility assumption
setting process and the volatilities in the table above
are representative for each asset class over the next 10
shown above are in local currency terms. For emerging
market equities, global private equity and global fund
of hedge funds the local currency is taken to be USD.
volatility assumptions apply to bond investments in these
markets. This is because as yields fall towards 0% (or
even below), the potential for further significant declines
Correlations
IL
FI
EM Eq
Gbl PE
Gbl
FoHF
-0.1
0.0
0.0
-0.1
-0.2
-0.2
-0.1
0.0
-0.2
0.0
0.1
0.1
0.0
0.1
0.1
0.4
0.3
0.4
0.4
0.3
0.3
0.3
0.9
0.9
0.7
0.9
0.9
0.8
0.6
0.7
1
0.9
0.7
0.9
0.9
0.8
0.7
0.8
1
0.7
0.9
0.9
0.8
0.6
0.7
1
0.7
0.7
0.6
0.4
0.5
1
0.8
0.8
0.6
0.7
1
0.8
0.6
0.7
1
0.6
0.7
1
0.5
IL
FI
CB
RE
UK Eq
US Eq
Eur Eq
Jap Eq
1
0.5
0.4
0.1
-0.1
-0.1
-0.1
0.0
-0.1
1
0.8
0.1
-0.2
-0.2
-0.2
-0.1
1
0.1
0.1
0.1
0.1
1
0.4
0.4
1
CB
RE
UK Eq
US Eq
Eur Eq
Jap Eq
Can Eq CHF Eq
Can Eq
CHF Eq
EM Eq
Gbl PE
Gbl FoHF
1
Domestic Inflation-Linked Government Bonds
UK Equities
Canada Equities
Domestic Fixed Income Government Bonds
US Equities
Switzerland Equities
Domestic Investment Grade Corporate Bonds
Europe ex UK Equities
Emerging Market Equities
Domestic Real Estate / Property
Japan Equities
Global Private Equity
Global Fund of Hedge Funds
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
The matrix above sets out representative correlations
Our correlations are forward looking and not just historical
assumed in our modelling work, shown on a rounded basis.
averages. In particular, we think that in many ways the
All correlations shown above are in local currency terms and
experience of this millennium has been quite different
can be used by UK, US, European, Canadian and Swiss
from the previous 20 years, being more cyclical in nature
investors for the asset classes where return and volatility
with less strong secular trends. This has many implications.
assumptions exist (e.g. Swiss real estate is not modelled).
For example, the equity/government bond correlation
A different set of correlations apply for Japanese investors.
in the table above is negative, which also incorporates
Correlations are highly unstable, varying greatly over time, and
this feature is captured in our modelling, where we employ a
more complex set of correlations involving different scenarios.
the feature that this correlation is negative in stressed
environments. The lead article to the 30 June 2014 Capital
Market Assumptions publication included further detail on
the drivers of the equity/government bond correlation.
Aon Hewitt 17
Capital Market
Assumptions Methodology
Overview
Equities
Aon Hewitt’s Capital Market Assumptions are our asset class return, volatility
and correlation assumptions. The return assumptions are ‘best estimates’
of annualised returns. By this we mean median annualised returns – that
is, there is a 50/50 chance that actual returns will be above or below
the assumptions. The assumptions are long term assumptions, based
on a 10 year projection period and are updated on a quarterly basis.
Equity return assumptions are built using a discounted cashflow analysis.
Forecast real (after inflation) cashflows payable to investors are discounted
and their aggregated value is equated to the current level of each equity
market to give forecast real (after inflation) returns. These returns are then
converted to nominal returns using our 10 year inflation assumptions.
Material uncertainty
Given that the future is uncertain, there is material uncertainty in all
aspects of the Capital Market Assumptions and the use of judgement
is required at all stages in both their formulation and application.
Allowance for active management
The asset class assumptions are assumptions for market returns, that is
we make no allowance for managers outperforming the market. The
exceptions to this are the private equity and hedge fund assumptions
where, due to the nature of the asset classes, manager performance
needs to be incorporated in our Capital Market Assumptions. In
the case of hedge funds we assume average manager performance
and for private equity we assume a high performing manager.
Inflation
When formulating assumptions for inflation, we consider
consensus forecasts as well as the inflation risk premium
implied by market break-even inflation rates.
Fixed income government bonds
We model a diversified private equity portfolio with allocations
to leveraged buyouts, venture capital, and mezzanine and
distressed investments. Return assumptions are formulated
for each strategy based on an analysis of the exposure of each
strategy to various market factors with associated risk premia.
Real estate / property
Real estate returns are constructed using a discounted cashflow
analysis similar to that used for equities, but allowing for the
specific features of these investments such as rental growth.
Hedge funds
We construct assumptions for a range of hedge fund strategies (e.g.
equity long/short, equity market neutral, fixed income arbitrage, event
driven, distressed debt, global macro, managed futures) based on
an analysis of the underlying building blocks of these strategies.
We use these individual strategies to formulate a fund of hedge funds’
assumption which is quoted in the Capital Market Assumptions.
Currency movements
The government bond assumptions are for portfolios of bonds
which are annually rebalanced (to maintain constant duration).
This is formulated by stochastic modelling of future yield curves.
Assumptions regarding currency movements are related to
inflation differentials.
Inflation-linked government bonds
Volatility
We follow a similar process to that for nominal government bonds, but with
projected real (after inflation) yields. We incorporate our inflation profiles
to construct nominal returns for inflation-linked government bonds.
Corporate bonds
Corporate bonds are modelled in a similar manner to government
bonds but with additional modelling of credit spreads and
projected losses from defaults and downgrades.
Other fixed income
Emerging market debt and high yield debt are modelled in a
similar fashion to corporate bonds by considering expected returns
after allowing for losses from defaults and downgrades.
18
Private equity
Capital Market Assumptions
Assumed volatilities are formulated with reference to implied
volatilities priced into option contracts of various terms, historical
volatility levels and expected volatility trends in future.
Correlations
Our correlation assumptions are forward looking and result from inhouse research which looks at historical correlations over different
time periods and during differing economic/investment conditions,
including periods of market stress. Correlations are highly unstable,
varying greatly over time. This feature is captured in our modelling.
Contacts
Tapan Datta
T: +44 (0)20 7086 9076
[email protected]
Matthieu Tournaire
T: +44 (0)20 7086 9430
[email protected]
Disclaimer
This document has been produced by Aon Hewitt’s
Global Asset Allocation Team, a division of Aon plc and
is appropriate solely for institutional investors. Nothing
in this document should be treated as an authoritative
statement of the law on any particular aspect or in any
specific case. It should not be taken as financial advice and
action should not be taken as a result of this document
alone. Consultants will be pleased to answer questions on
its contents but cannot give individual financial advice.
Individuals are recommended to seek independent financial
advice in respect of their own personal circumstances.
The information contained herein is given as of the date
hereof and does not purport to give information as of
any other date. The delivery at any time shall not, under
any circumstances, create any implication that there
has been a change in the information set forth herein
since the date hereof or any obligation to update or
provide amendments hereto. The information contained
herein is derived from proprietary and non-proprietary
sources deemed by Aon Hewitt to be reliable and are not
necessarily all inclusive. Aon Hewitt does not guarantee
the accuracy or completeness of this information
and cannot be held accountable for inaccurate data
provided by third parties. Reliance upon information
in this material is at the sole discretion of the reader.
Past results are not indicative of future results. The
tables and graphs included herein present expected
returns, which are forward-looking expectations
by AHIC based on informed historical results and
internal analysis. These do not represent actual
historical results. There can be no guarantee that
any of these expected results will be achieved. The
Capital Market Assumptions (CMAs) represents
AHIC’s outlooks on capital markets and economies
over the next 10 years. These views are constructed
based on our framework of analyzing fundamental,
valuation and long-term drivers of capital markets.
Opinions and estimates offered constitute our judgment
and are subject to change without notice, as are statements
of financial market trends, which are based on current
market conditions. We believe the information provided
here is reliable, but do not warrant its accuracy or
completeness. The views and strategies described may
not be suitable for all investors. Opinions referenced
are as of December 2016, and are subject to change
due to changes in the market, economic conditions or
changes in the legal and/or regulatory environment and
may not necessarily come to pass. This information is
provided for informational purposes only and should
not be considered tax, legal, or investment advice.
References to specific securities, asset classes and
financial markets are for illustrative purposes only and
are not intended to be, and should not be interpreted
as, recommendations. This material is distributed for
informational purposes only. The information contained
herein is based on internal research derived from various
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while not guaranteed as to the accuracy or completeness,
has been obtained from sources we believe to be reliable.
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or solicitation of any kind and may not be treated as such,
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Aon Hewitt 19
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