Capital Market Assumptions – Q1 Update

Key Takeaways

• We have witnessed a dramatic repricing of risk in the first few months of 2025. Following the “Liberation Day” tariffs, US equity markets have posted their 16th worst two-day period since 1928.
• The once unstoppable US large cap equity market has underperformed its global counterparts since Trump’s election on November 4, 2024, with a rotation into non-US equities and “risk-off” assets underway.
• Being both defensive and flexible is key for investors during these moments as trade policies could be reversed just as quickly as they have been imposed. We have written extensively about the risks looming over US equity markets for quite some time, with elevated valuations and market concentration being key themes of our capital market assumption (CMA) publications. 
   

Figure 1: Expectations relative to historical average (USD)

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Source: Invesco, estimates as of December 31, 2024. Proxies listed in disclosures below. These estimates are forward-looking, are not guarantees, and they involve risks, uncertainties, and assumptions. Please see below for information about our CMA methodology. These estimates reflect the views of Invesco Solutions; the views of other investment teams at Invesco may differ from those presented here. The asset class assumptions are not a promise of future performance. Indexes are unmanaged and used for illustrative purposes only. It is not possible to invest directly in an index.  
 

Invesco Solutions provides forecasts for 170+ assets in over 20 currencies, including 10 private assets. For additional CMA data, views, or analysis, please reach out to your Invesco representative.

Important information 
Asset class proxies: 
US HY muni represented by the BBG muni bond HY index. 
US muni represented by the BOA ML US muni index. 
US broadly synd loans represented by the CSFB leverage loan index. 
China RMB credit represented by the BBG China corporate  index. 
US HY corps represented by the BBG US HY index. 
US IG corp represented by the BBG US IG index. 
US TIPS represented by the BBG US TIPS index. 
EM agg represented by the BBG EM agg index. 
US agg represented by the BBG US agg index. 
US tsy represented by the BBG US tsy index. 
US MBS represented by the BBG US MBS index. 
Global agg represented by the BBG global agg index. 
Global agg ex-US represented by the BBG global agg ex-US index. 
US large cap represented by the S&P 500 index. 
US mid cap represented by the Russell midcap index. 
Japan equity represented by the MSCI JP index. 
Global equity represented by the MSCI ACWI index. 
US small cap represented by the Russell 2000 index. 
Canada equity represented by the S&P TSX index. 
EAFE equity represented by the MSCI EAFE index. 
Europe equity represented by the MSCI Europe index. 
UK large cap represented by the FTSE 100 index. 
China large cap represented by the CSI 300 index. 
APAC ex-JP represented by the MSCI APXJ index. 
EM equity represented by the MSCI EM index. 
US REITs represented by the FTSE NAREIT equity index. 
HFRI hedge funds represented by the HFRI HF index. 
Global REITs represented by the FTSE EPRA/NAREIT developed index. 
Global infra represented by the DJ Brookfield global infra index. 
GS commodities represented by the S&P GSCI index.

Capital Market Assumptions methodology

We employ a fundamentally based “building block” approach to estimating asset class returns. Estimates for income and capital gain components of returns for each asset class are informed by fundamental and historical data. Components are then combined to establish estimated returns. Here, we provide a summary of key elements of the methodology used to produce our long-term (10-year) estimates. 

Fixed income returns are composed of:

• Average yield: The average of the starting (initial) yield and the expected yield for bonds.
• Valuation change (yield curve): Estimated changes in valuation given changes in the Treasury yield curve.
• Roll return: Reflects the impact on the price of bonds that are held over time. Given a positively sloped yield curve, a bond’s price will be positively impacted as interest payments remain fixed, but time to maturity decreases.
• Credit adjustment: Estimated potential impact on returns from credit rating downgrades and defaults.

Equity returns are composed of:

• Dividend yield: Dividend per share divided by price per share.
• Buyback yield: Percentage change in shares outstanding resulting from companies buying back or issuing shares.
• Valuation change: The expected change in value given the current price/earnings (P/E) ratio and the assumption of reversion to the long-term average P/E ratio.
• Long-term (LT) earnings growth: The estimated rate of the growth of earnings based on the long-term average real GDP per capita and inflation.

Currency adjustments are based on the theory of interest rate parity (IRP), which suggests a strong relationship between interest rates and the spot and forward exchange rates between two given currencies. Interest rate parity theory assumes that no arbitrage opportunities exist in foreign exchange markets. It is based on the notion that, over the long term, investors will be indifferent between varying rates of returns on deposits in different currencies because any excess return on deposits will be offset by changes in the relative value of currencies. 
For volatility estimates for the different asset classes, we use rolling historical quarterly returns of various market benchmarks. Given that benchmarks have differing histories within and across asset classes, we normalize the volatility estimates of shorter-lived benchmarks to ensure that all series are measured over similar time periods. 
Correlation estimates are calculated using trailing 20 years of monthly returns. Given that recent asset class correlations could have a more meaningful effect on future observations, we place greater weight on more recent observations by applying a 10-year half-life to the time series in our calculation. 
Arithmetic versus geometric returns. Our building block methodology produces estimates of geometric (compound) asset class returns. However, standard mean-variance portfolio optimization requires return inputs to be provided in arithmetic rather than in geometric terms. This is because the arithmetic mean of a weighted sum (e.g., a portfolio) is the weighted sum of the arithmetic means (of portfolio constituents). This does not hold for geometric returns. Accordingly, we translate geometric estimates into arithmetic terms. We provide both arithmetic returns and geometric returns, given that the former informs the optimization process regarding expected outcomes, while the latter informs the investor about the rate at which asset classes might be expected to grow wealth over the long run.

Investment risk: 
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations), and investors may not get back the full amount invested.  Invesco Solutions develops CMAs that provide long-term estimates for the behavior of major asset classes globally. The team is dedicated to designing outcome-oriented, multi-asset portfolios that meet the specific goals of investors. The assumptions, which are based on 5- and 10-year investment time horizons, are intended to guide these strategic asset class allocations. For each selected asset class, we develop assumptions for estimated return, estimated standard deviation of return (volatility), and estimated correlation with other asset classes. This information is not intended as a recommendation to invest in a specific asset class or strategy, or as a promise of future performance. Estimated returns are subject to uncertainty and error and can be conditional on economic scenarios. In the event a particular scenario comes to pass, actual returns could be significantly higher or lower than these estimates. 
Unless otherwise stated, all information is sourced from Invesco, in USD and as of September 30, 2024. The opinions expressed are those of the Invesco Solutions team and may differ from the opinions of other Invesco investment professionals. Opinions are based upon current market conditions and are subject to change without notice. Past performance is not a guarantee of future results. Diversification and asset allocation does not guarantee a profit or eliminate the risk of loss. 
Invesco Advisers, Inc. is an investment adviser; it provides investment advisory services to individual and institutional clients and does not sell securities.