After a prosperous 2016 for equity investors, global markets sustained their upward momentum in the first quarter of 2017 with most major indices ending higher. Mounting evidence of stronger global economic growth, combined with hopes for tax reform and deregulation in the United States, lent confidence to investors worldwide. Foreign markets led the way during the quarter, outperforming U.S. stocks.
Asset class returns for the quarter were as follows:
First Quarter 2017
|Barclays U.S. Govt./Credit—Int.||Fixed Income||
|S&P 500||Large U.S. Stock||
|Russell 2000||Small U.S. Stock||
|MSCI ACWI ex-USA||Foreign Stock||
|S&P Global REIT||Real Estate Securities||
On March 9, the U.S. stock market reached the eight-year anniversary of the current bull market, and three widely-followed U.S. indices—the Dow Jones Industrial Average, the NASDAQ Composite, and the S&P 500—celebrated by notching all-time highs. Since February 2009, a dollar invested in the U.S. market (with dividends reinvested) has turned into $3.87, an 18.2% annual return. Foreign equities have not done as well, but a dollar invested abroad has still turned into $2.26, a 10.6% annual return.
This has been a rewarding period for investors who persevered through the dark days of 2008-2009 and maintained a significant allocation to equities. But by historical standards, this bull market is getting rather long in the tooth. As investors turn their attention to the future, we are often asked: What kind of returns are reasonable to expect over the next five, ten, or twenty years?
The short answer is that we believe future returns on both stocks and bonds are likely to be materially lower than historical averages, and almost certainly lower than the outsized market returns of the past 30 years. A recent report by McKinsey & Company titled Diminishing Returns: Why Investors May Need to Lower Their Expectations (May 2016) sheds light on four trends which have powered financial returns for the past several decades, but which are now showing signs of reversing course and becoming headwinds rather than tailwinds for global asset prices. In this letter, we give a brief overview of these trends and conclude with implications for investors. Before we start, it is important to note that we are not predicting a near-term market crash, or even a significant correction—although either or both of these are certainly possible. Lower average returns can manifest themselves in a variety of ways, ranging from the sudden and dramatic, to the glacial and insidious. No one knows exactly how it will all play out.
So why do we expect lower average returns on stocks and bonds?
Inflation has more room to go up than down. Many investors today have lived their entire adult lives with relative price stability. Inflation has been modest for the last 25 years, fluctuating within a range of zero to four percent. Contrast this tranquility with the sky-high inflation of the late 1970s, when annual inflation exceeded 10%. In fact, inflation worldwide has dropped to such low levels that some countries have been concerned about deflation, an overall decline in prices.
Inflation affects the economy in numerous ways, with the most obvious effects being the increase in prices for consumer goods, higher costs of living, and higher prices for the labor and raw materials that businesses use to produce finished goods and services. Inflation also affects the stock and bond markets. Rising inflation can lead to lower price-to-earnings ratios, resulting in decreased valuations for stocks. While higher inflation will cause bond issuers to pay savers a higher coupon rate on new bonds, it will tend to depress the value of existing bonds.
Interest rates may continue to rise from current low levels. In late 1981, the yield on the 10-year U.S. Treasury bond peaked at 15.8%. Over the ensuing 35 years, interest rates fell dramatically, providing the backdrop for fantastic bond market returns and a significant boost for stock returns as well. The low point for interest rates may have come last July, when the 10-year Treasury yield briefly dipped below 1.4%. This benchmark yield is now about a percentage point higher, at 2.4%, and the Federal Reserve (Fed) seems to finally believe the U.S. economy has enough momentum to continue hiking short-term rates. Higher rates mean that borrowing becomes costlier for companies and consumers. Higher mortgage rates could adversely impact the housing market, dampen labor force mobility, and curtail economic growth (see below).
While we believe a return to more “normal” bond yields (in the 4% to 6% range) would be a healthy development for savers, the possibility remains of an extended period of rates grinding higher, as the U.S. experienced from 1950 to 1981. This was an extremely challenging period for fixed income investors, particularly those who purchased long-term bonds; an investor in long-term U.S. government bonds would have lost two-thirds of his purchasing power during this timeframe, even with all interest payments reinvested!
Economic growth, as measured by gross domestic product, has slowed. Over the last eight years, the U.S. economy has been aided by very accommodative monetary policy. Even with this unprecedented support from the Fed, the U.S. economy has grown at just 2% per year since the financial crisis, well below the average rate of 3.25% since 1950. While the headline unemployment rate has fallen significantly since 2009, labor force participation has stagnated. Changing demographics (baby boomers retiring, younger workers entering the workforce at later ages, etc.) have caused growth of the workforce in the U.S. to slow compared to historical norms. The United Nations recently issued a report projecting that the U.S. working age population may shrink from 66% of the population to below 60% by 2035, which is a rather gloomy outlook, considering the working age population in the U.S. has been steadily growing since the 1970s. Historically, immigration has been a key source of labor and an engine of U.S. economic growth, but this could change given the policy preferences of the new administration and Congress.
Corporate profits may be challenged. In the long run, stock prices track the growth of corporate profits. Over the past three decades, corporate profits have grown much faster than global economic output. Lower interest rates helped bolster company profits over the last several decades as companies were able to borrow cheaply to fund acquisitions or stock buybacks. Globalization and open trade policies have increased corporate profits, as companies optimized supply chains worldwide and gained new revenue streams from foreign markets. According to McKinsey, approximately one-third of U.S. corporate profits now come from overseas customers (nearly twice what it was in 1980).
Today, however, large corporations are facing tougher competition, which could ultimately reduce their profits. Many new, local competitors have arisen in emerging markets. These nimble firms have low cost structures and can compete at much lower prices and with less regulation. Technology platforms have the potential to create enormous disruption of longstanding business models. Start-up costs for web-based businesses are minimal, allowing new companies the opportunity to immediately take market share from competitors. In the near-term, profit forecasts may have assumed that corporate tax cuts would materialize under the new administration. If these cuts are not as large as expected, or do not occur as quickly as initially forecasted, expectations for corporate profits will almost certainly fall.
What should long-term investors do if these macroeconomic factors reduce stock and bond returns in the coming years?
Temper return expectations. Given the stock market’s strong performance over the last eight years and the low inflation/low interest rate environment we are in today, investors would be wise to reduce their expectations for future market returns. Over the last 30 years, annualized returns for both domestic stocks and bonds were considerably higher than their long-term averages. Neither stocks nor bonds appear cheap today.
Save more and spend less. In addition to asset allocation and long-term investment returns, your saving rate is an important factor in the success of your financial plan. With human longevity increasing and prices set to rise at some point, saving more is a hedge against future uncertainty.
Stay diversified. By definition, a diversified portfolio will always have an asset class or a sector that is not working, or at least not working as well as its other components. One timely example is international markets, which have substantially underperformed the U.S. stock market over the past six years. However, over the last 20 years (1997-2016), performance has been about even. If investors were to allocate capital only to U.S. markets, they would be ignoring over half of the world’s market capitalization and potential sources of return. Not only should investors stay diversified globally, but it is also important to remain diversified across the globe, diversifying across asset classes (large cap, mid/small cap, real estate, etc.) and investment styles (e.g. growth vs. value).
Do not reach for yield. When buying bonds or bond funds, focus on high credit quality and keep bond maturities in the short-to-intermediate part of the yield curve to limit drawdowns in the event of rising interest rates.
Do not panic. Typically, more money is lost trying to time and prepare for market volatility than is actually lost during market volatility. It is perfectly normal to be nervous in times of uncertainty, but emotionally-charged actions typically lead to financial mistakes.
While we cannot predict where the market will go from here, our goal is to construct all-weather portfolios for our clients that are prepared for a variety of market outcomes. We remain broadly diversified among multiple asset classes and continue to hold high-quality, shorter-term bonds to preserve wealth and mitigate portfolio volatility, as well as a diversified global portfolio of stocks to provide long-term growth of capital and a hedge against inflation.