The expected risk premium for the Global Market Index (GMI) ticked up in July, touching a two-month high. GMI — an unmanaged, market-value weighted mix of the major asset classes — is projected to earn an annualized 3.7% over the “risk-free” rate in the long term. (For details on the equilibrium-based methodology that's used to generate the forecasts each month, see the summary below). Today's updated estimate, which is based on data through the close of last month, increased 10 basis points from the previous projection.

Adjusting for short-term momentum and longer-term mean-reversion factors (defined below) pared GMI's current ex ante risk premium to an annualized 3.6%.

GMI's risk premia forecasts remain substantially below the index's realized performance in recent history, although the gap has been narrowing lately due to lesser trailing returns. GMI earned an annualized 8.5% risk premium for the trailing 3-year period through July 2015. Based on the current projection, GMI's implied performance in the years ahead will be considerably lower. That's a sign for anticipating that multi-asset class strategies in general will endure stronger headwinds vs. results over the last several years.

Here's a summary of the current risk premia projections for GMI and the major asset classes that comprise the benchmark:

Here's a recap of how GMI's risk premia forecasts have evolved in recent months:

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 (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)