Risk Premia Forecasts: Major Asset Classes – Feb. 2

The projected risk premium for the Global Market Index (GMI) was unchanged for a second month in a row in January, holding steady at the highest level in over two years. GMI, an unmanaged market-value weighted mix of the major asset classes, is currently projected to earn an annualized 4.3% over the long term – matching the two previous estimates (here and here).

Although GMI’s forecast was stable last month, the current risk-premium outlook continues to mark a rebound from the below-3.0% estimates in late-2015 and early 2016.

Adjusting for short-term momentum and longer-term mean-reversion factors (defined below) reduces GMI’s current ex ante risk premium to an annualized 4.1%, which is also unchanged from the previous estimate.

Meanwhile, the realized risk premium for GMI for the trailing three-year period through last month increased sharply to 4.3% from 3.0% in the previous update. As a result, the trailing 3-year performance matches the long-term forecast. Compared with the historical record since 2012, however, the current trailing return is still quite low.

For some historical perspective, here’s a recap of how GMI’s risk premium estimates have evolved over the last two years:

Turning to what the markets actually delivered, here’s a chart of rolling three-year annualized risk premia for GMI, US stocks (Russell 3000) and US Bonds (Bloomberg Barclays Aggregate Bond Index) through last month.

Finally, here’s a summary of the methodology and rationale for the estimates above. The basic idea is to reverse engineer expected return based on assumptions about risk. Rather than trying to predict return directly, this approach relies on the somewhat more reliable model of using risk metrics to estimate performance of asset classes. The process is relatively robust in the sense that forecasting risk is slightly easier than projecting return. With the necessary data in hand, we can estimate the implied risk premia using the following inputs:

? an estimate of GMI’s expected market price of risk, defined as the Sharpe ratio, which is the ratio of risk premia to volatility (standard deviation).
? the expected volatility (standard deviation) of each asset
? the expected correlation for each asset with the overall portfolio (GMI)