Are capital markets assumptions still valid for longer term strategic asset allocation?

It is important to define what is meant by capital market assumptions. These are estimations that attempt to describe how an asset class may behave over the longer-term, typically five to ten years. However, despite this longer-term view, they are often refreshed quarterly taking into consideration the latest market news.
Given the current market environment and levels of market volatility we are experiencing, it is inevitable that these estimations will be revised which may have a knock-on effect to the underlying strategic asset allocations provided, although the extent of this is dependent upon how the estimations are employed within the strategic asset allocation process, as not all processes are the same.

Capital market assumptions typically cover three core components: expected returns, expected volatility and co-variance, or correlation matrices. The first of these components, expected returns, typically take a riskfree rate as a starting point which is typically represented by the yield on a ten-year bond. In the UK, that is
currently around 0.2%, down from 0.8% pre-Covid. Added to that are risk premia which will vary depending on the asset class under consideration. For example, for equities the risk premium normally includes growth expectations and dividend growth expectations. Mean reversion or looking at the current market levels for an asset class relative to where it has been historically, is another influential factor.

Taking all these components together, we would expect returns for government bonds to fall given the reduction in yields. However, for equities whilst the expectations for growth and dividends payments have fallen, the mean reversion component will offset it and all things considered, we would therefore expect returns across this asset class to increase.

What does this mean for strategic asset allocations? As stated previously, much depends on how reliant their underlying construction process is to the inputs of the capital market assumptions. Square Mile’s strategic asset allocation process, however, is less reliant on the estimations provided and although it is reviewed
when they are updated, it is unlikely to change in the near future.

Chris Fleming, Investment Services Director

Park Hall Financial Services Limited is authorised and regulated by the Financial Conduct Authority.

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