Advisors are in the business of building portfolios for the long term, based on how investing vehicles and asset classes have performed in the past. If researchers at McKinsey & Co. are right, however, investment returns from U.S. and European equities and bonds over the next few decades will drop by 150 to 400 basis points from returns delivered from 1985-2014. And that’s assuming that economic growth recovers to the trend rate of the past 50 years, according to the May McKinsey Global Institute (MGI) report, Diminishing Returns: Why Investors May Need to Lower Their Expectations.
The paper says that technological change in corporations that increase productivity and earnings could change its forecasts, and acknowledges that “for reasons of simplicity,” its past and future returns models excluded real estate, alternative investments and emerging-market investments. Including those asset classes and strategies “could lift average returns for investor portfolios” in the future, McKinsey admitted, and said future research might include them. It also said that rather than consider its research findings as forecasts, its intent is to allow both professionals and individuals to “understand the drivers of returns and the trends that could dampen future investment performance … and their implications, so that they can reset their expectations.”
First, a look at the past. For the 100 years ending in 2014, U.S. equities returned 6.5% annualized, the report says, while in the past 30 years ended 2014, U.S. equities returned 7.9%. U.S. bonds returned an annualized 1.7% for the past 100 years and 5.0% for the last 30 years. European equities returned 4.9% for the past 100 years and 7.9% for the last 30, while European bonds returned 1.6% for the 100 years and 5.9% for the last 30.
Those 30-year returns for U.S. equities, the researchers say, were 1.4 percentage points above the 100-year average and 2.2 percentage points higher than the 50-year average. Western European equity returns for the last 30 years also exceeded the 100-year and 50-year averages, while fixed-income investments, as measured by total real returns on government bonds, were also considerably higher in the U.S. and Europe in the 1985-to-2014 period than they had been from 1915 to 2014.
McKinsey calls those periods a “golden era” that has informed individuals and professional investors’ overconfidence that future returns will match those of the last 30 or even 100 years. But they were made possible, the researchers said, by a combination of factors, including low inflation, high global GDP growth and higher corporate profits as revenue from new markets increased the top line while technology helped lower costs and corporate taxes declined.
Some of those growth drivers, the researchers point out, have “run their course,” as recent GDP slowdowns and interest rate declines have shown.
As an example of how expectations have not yet changed to match the new data, the study cites the assumptions of U.S. public pension fund managers in the U.S. who expect real returns of 8% for a 70% stock/bond portfolio mix.
So what about future returns? While the future path of interest rates is unclear, the steep declines from the high interest rates of the 1980s are unlikely to be repeated, the MGI researchers say: ”Rates are either beginning to shift direction or have little room to fall further.”
Global GDP growth was fueled by a “simultaneous increase in productivity and employment … over the past 50 years, but that confluence no longer exists,” the researchers write, partly because of an aging world, where the number of working-age adults “has stalled.” The decline in employment growth, the MGI researchers say, will cause a 40% drop in global GDP over the next 40 years, and in the U.S., that “implies that real GDP growth could slow to 1.9% over the next 20 years.”
Corporate profits worldwide will be affected by three major trends.
First is new competition from emerging markets, noting that EM companies “often play by different rules,” including lower costs and a “willingness to accept lower returns.”
One example: Chinese firms already make up some 20% of the Fortune Global 500; U.S. and European companies account for only 54%.
The third trend affecting corporate profits, especially large-cap ones, is increased competition from small and medium-size companies who are taking advantage of online platforms to achieve scale. For example, Alibaba, eBay, Amazon “and other online platforms are now providing a way for thousands of small and medium-sized enterprises to achieve immediate global reach and compete with far larger players.”
So flat interest rates, slower global economic growth and lower corporate profits will all affect equity and bond returns. If such is the case, what are the solutions?
For public pension plans, the solutions — “none of them particularly palatable” — would include governments increasing their pension contributions, which would have other unpalatable consequences; reducing future benefits, increasing the retirement age or investing in higher-risk, potentially higher-return assets. For asset managers, already dealing with big growth in passive investments, McKinsey suggests one option would be to include more alternative investments in their investing vehicles. Another would be to allocate away from “asset-heavy sectors to idea-intensive ones,” such as pharmaceuticals, media and IT companies, where the “wide gap between the most profitable firms and others” would allow a stock-picking active manager to shine.
For individuals, McKinsey projects that such a “long period of lower returns would require painful adjustments,” that would include saving more for retirement, retiring later or cutting expenses in retirement (though saving more and cutting costs would both have an effect on the broader economy). Here’s the McKinsey example.
A 30-year-old who can expect to receive a 4.5% real return rather than the 6.5% real return on a standard 60/40 portfolio over the next 20 years would see $100 invested grow to only $160-$200. Under the prior 6.5% real return, that same $100 would grow to $370 over 20 years.
To make up for that difference, the 30-year-old “would have to work seven years longer or almost double his or her saving rate.” If returns were even lower — 3.5% in real terms, then our millennial would need to work another nine years or more than double annual savings.
To simplify the argument, the McKinsey study suggests that investors would need to work longer, retire later and expect a lower standard of living once in retirement.
Or is the study missing something? An emailed statement from the big RIA firm Regent Atlantic based in Morristown, New Jersey, commented on the study, finding much agreement. Lower returns are likely, it’s good to reset expectations of future returns (“we have been advising clients to temper expectations in recent years”) and particularly McKinsey’s point on the low return potential of fixed income.
However, Regent Atlantic took issue with McKinsey’s “limited” solutions for individuals, along with its take on retiree spending rates, which from its experience with actual clients said “grow much slower than common wisdom suggests.”
Regent Atlantic is also optimistic that investors can adapt to this lower-return environment, especially if steps are taken on three issues.
- Since the biggest risk to returns in bonds is inflation, investors can hedge against this risk using inflation-protected bonds.
- Excluding the role of emerging markets investing is a mistake, since EM investing offers “lower starting valuations and higher potential returns.”
- Even in developed markets, another area “McKinsey did not study,” smaller companies “have historically provided a return premium.”
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