How Scared Should we be About Future Returns?

by
Cullen Roche
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McKinsey had a really nice piece this week on the future of financial market returns. The basic conclusion – lower your expectations and hunker down for some lean years in the financial markets.  McKinsey’s says that equities have benefited from unusually favorable conditions in the last 30 years such as low valuations, falling inflation, falling interest rates, strong demographic growth, high productivity gains and strong corporate profits. Specifically, they say:

“Despite repeated market turbulence, real total returns for equities investors between 1985 and 2014 averaged 7.9 percent in both the United States and Western Europe. These were 140 and 300 basis points (1.4 and 3.0 percentage points), respectively, above the 100-year average. Real bond returns in the same period averaged 5.0 percent in the United States, 330 basis points above the 100-year average, and 5.9 percent in Europe, 420 basis points above the average.”

That’s a nice clean view of the future relative to long-term returns. I think McKinsey is dead right – the last 30 years were unusual and something closer to the 100 year average is probably reasonable. I’ve stated in the past that the math here isn’t terribly controversial (or shouldn’t be). If a 50/50 stock/bond portfolio has generated 30 year average returns of 9.5% then we should expect the future returns to be lower or more volatile. In other words, you can, with near certainty, expect that the high risk adjusted returns of the last 30 years are gone.

Why is this a certainty? Well, it’s a simple function of the current interest rate environment. Because the post-1980 era involved a huge bond bull market the risk adjusted returns of a balanced portfolio were unusually high. For instance, from 1985-2015 a 50/50 stock/bond portfolio posted returns of about 9.5% with a Sharpe ratio of 0.7 and a Sortino ratio of 1.5. That’s because the bond piece, which is inherently more stable, generated average annual returns of 7% with a Sharpe ratio of 0.76 and an eye popping Sortino ratio of 2.12 while the stock piece generated annual returns of 12.5% with a Sharpe ratio of 0.5 and a Sortino of just 0.92. In other words, bond investors have done extraordinarily well over the last 30 years thanks to the favorable tailwind of falling inflation and falling interest rates. And those outsized bond returns had a hugely positive impact on diversified investors.

We also know that the best predictor of future bond returns is current yields so, do the math on the 1985 starting overnight interest rate of 7.5% versus today’s rates of 0%.  A bond aggregate held for the next 10 years is unlikely to outpace the current yield of 2.25% by much. So, we know for a fact that the bond piece won’t generate anything close to the types of returns it did in the last 30 years. But there’s also good historical precedent here. In the 1940’s rates were as low as they are today. So, how did the bond market do?  It did okay, but it certainly wasn’t anything like the post-1980 period. From 1940-1980 bonds posted annual returns of 2.75%, but were very stable (much more stable than is commonly believe in a rising interest rate environment). The stock piece, however, performed very similarly to the post-1980 period with rates of returns from 1940-1980 at 12.4% vs 12.5% for the 1985-2015 period. As a result of this a balanced portfolio from 1940-1980 generated an average 8% return with a Sharpe ratio of 0.58, significantly lower than the average 10% return with Sharpe of 0.7 that we experienced in the last 30 years.  In other words, in the only reasonable historical precedent a balanced portfolio generated lower nominal and risk adjusted returns than the post-1985 period.

Now, I think backtests and historical references are a bit dangerous and overused by the financial community, but don’t think we need these historical precedents to establish a reasonable probability of future returns. All we need is a little common sense when comparing the next 30 years to the last 30 years. After all, we have empirical proof that most of those tailwinds are in fact waning. For instance:

1. Current interest rates are the best predictor of future returns in the bond market and this period is certain to be a low return period for future bond holders.
2. Valuations, which have a strong tendency to correlate with future returns, are high historically.
3. Demographic trends have shifted substantially in the last few decades from a world of higher growth to a much more modest pace of growth.
4. High productivity gains have waned and have now become an area of great concern for economists.
5. Corporate profits, as a share of national income, have never been higher as they rode the back of the liberalization of tax rates and regulation and could come under pressure given the anti-corporate climate we are entering.

I don’t think any of this should be terribly controversial and you don’t have to be an expert forecaster to see what’s coming. At the same time, we shouldn’t panic as some people have implied.  If the aggregate stock and bond markets generate anything close to that 8% return of the 1940-1980 period then most investors will still generate positive real returns. However, there are a few key takeaways here:

1. Understand the most important principles of portfolio construction so you can grow comfortable with a process and a plan.  See Understanding Modern Portfolio Construction.  
2. It’s time to temper expectations in the markets. The future is likely to be an era of lower returns and potentially bumpier returns, however, it doesn’t mean returns are going to be catastrophic.
3. It’s time to hunker down on your taxes and fees in your portfolio. As a % of assets, frictions will become increasingly important in a lower return environment.  See, Understanding your Real, Real Returns. 
4. Be patient! Find a good plan and learn to stick with it. The lower returns and bumpier returns will create periods of frustration for most investors. The grass will always look greener somewhere else. Switching in and out of plans and chasing the next hot guru will very likely result in higher taxes and fees leading to lower average returns.  See, How To Avoid the Problem of Short-Termism. 
5. Invest in yourself, continue to save and pour that savings into your portfolio. You might not get world beating returns from your portfolio in the coming 30 years, but we know cash will be the riskiest asset in the future as it will guarantee a negative real return in such a low interest rate environment.  See, Saving is not the Key to Financial Success.  
6. Be careful reaching for yield. All safe assets aren’t created equal and reaching for yield in the wrong places could create more volatility without the guarantee of stable income.  See, Reaching for Yield or Reaching for Risk? 
7. Don’t let the scaremongers get to you. If the future is one of lower returns and bumpier returns there will be lines of people trying to sell you something in exchange for your fear. These people should not be trusted.  The world of the future might not be the gangbusters growth period of the 80’s and 90’s, but it also won’t be the end of times.

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