PALTRY RETURNS AHEAD
Many investors are behaving like ‘generals who are always prepared to fight the last war’
Investors disappointed by the performance of stocks since the start of the new millennium have found solace in the 6.7% annual return of Canadian investment grade bonds. Bond investors enjoyed an annual real (i.e. net of inflation) return of 4.6%, a hefty premium to historic norms. Now, with the stock market perking up, many investors are looking forward to more favourable returns adding a little more gust to their sails in the years ahead.
Unfortunately, research emanating from the London Business School, as outlined in the Credit Suisse Global Investment Returns Yearbook 2013, suggests that such optimism may be misplaced. Professors Elroy Dimson, Paul Marsh and Mike Staunton painstakingly analyzed the returns of treasury bills, long-term government bonds and stocks in 22 countries from 1900 to 2012 assessing the relationship between yields, valuation and interest rate levels and subsequent real returns.
Their conclusion: Real returns over the next 20 to 30 years are going to be much lower than those experienced historically. What is alarming is just how low. They predict that investors in long- term government bonds will earn an annual real return just slightly above 0%. As dismal as this forecast is, it is still higher than the negative - 0.5% annual real return they expect from treasury bills. Their long-term outlook for global stocks is higher — an annual real return of 3.0% to 3.5% — but this is still well below the norm of 5% experienced since 1900.
Many investors may find that they’ve charted their course in the wrong direction
Why such a tepid outlook? Because they believe today’s low-interest environment will persist longer than many investors expect. A global shortage of safe assets, a bulge of Baby Boomers heading into retirement and a profusion of maturing pension plans all reinforce the demand for government bonds. Furthermore, with long-term bond yields barely matching inflation today, any upsurge in rates will impose deflating capital losses on bond holders.
In their view, the historic real stock return of 5.0% per annum overstates the premium that investors demand for the risk of investing in equities. Stock markets now are much more diversified, transparent and liquid than they were in the first half of the last century. Hence, investors nowadays are satisfied with a much lower dividend yield than in yesteryears. One need only compare the current 2.7% dividend yield on global stocks to the average of 4.1% since 1900. And lower dividend yields imply lower future returns. Also, in the past, periods of low interest rates like today have often been followed by weak equity returns.
Of course, any projection is just an educated guess. However, the mathematics of bond returns is such that, at today’s miniscule bond yields, only a scenario of outright deflation results in meaningful real returns over the next decade. Similarly, there is no escaping the fact that stocks are more richly valued today than they were a century ago and that, given the structural limits to profit growth, historic stock returns likely overstate those we can expect in the future.
In this new world of low real returns, many investors may find that they’ve charted their course in the wrong direction. Like the proverbial “generals who are always prepared to fight the last war,” many investors, haunted by the shattering impact of the market decimation of 2008-2009, have loaded their portfolios with safe assets — treasury bills and investment grade bonds. The vital question they need to ask themselves now is — “Does my portfolio have enough assets with the potential for satisfactory real returns to achieve my long-term financial goals?”
Many are likely to discover that they need to increase their allocation to stocks. Other potential higher return options are also available. On the fixed-income side, preferred shares, high yield bonds and mortgage funds are alternatives.
REITs and infrastructure combine opportunities for both potential growth and cash flow. For high net worth investors, private equity and mezzanine debt funds offer the possibility of higher returns.
A sound investment plan is built around both the risk and long-term return outlook of assets. While investors may be powerless to change the low real returns that have been spotted on the horizon, they can and should adjust their sails.