“Glory days, well, they’ll pass you by
Glory days, in the wink of a young girl’s eye
Glory days, glory days” (Bruce Springsteen)
Glory Days for Investors: 1982-2016
Ronald Reagan and Paul Volcker helped plant the seeds for more than 30 years of growth in the stock and bond markets. Despite two steep equity market corrections in the 1990s, the S&P 500 Index (with dividends reinvested) provided double-digit annualized returns during the multi-decade rally. Bonds also rallied strongly, providing significant price appreciation as 10-year U.S. Treasury yields declined from double-digit to low single-digit levels.
American presidents typically receive too much credit for bull markets and too much blame for bear markets, but Reagan’s tax cuts and easing of regulatory burdens helped provide a market-friendly foundation for the U.S. economy. Federal Reserve Chairman Volcker’s actions were as controversial as Reagan’s economic policies, as the Volcker Fed took unpopular steps to reduce inflation. The “Volcker recession” caused unemployment rates to reach double-digit levels, but created a steep and sustainable decline in inflation. Investors also benefited from favorable demographics, with baby boomers at peak earning and spending years, as well as from increasing global trade. The “peace dividend” experienced during the 1990s after the fall of the Berlin Wall also provided a boost to markets.
‘One Step Up and Two Steps Back’ (Springsteen)
However, investors now face less favorable investment conditions, as many of the positive factors from past decades are slowing or reversing.
Inflation and interest rates: The Fed took extraordinary actions to prevent the U.S. economy from falling into a deflationary spiral. After several years of monetary stimulus, inflation is finally approaching the Fed’s 2% target. At current levels, there is more of a risk associated with rising interest rates and inflation than potential benefit from a decline in either.
Aging of the baby boomers: At the start of this decade, the ratio of Americans aged 20-65 to Americans aged 65 or older was more than 4.5 to 1. By 2030, the ratio is projected to decline to less than 3 to 1. Absent significant policy changes, the aging of the baby boomers will create significant budget challenges. Mandatory outlays, including entitlements such as Social Security, Medicare and Medicaid, are projected to exceed 80% of federal revenues by 2030. When interest costs are added to mandatory spending, the cumulated spending commitments are projected to be nearly 100% of federal revenues by 2030.
Geopolitical threats in a multipolar world: Terrorism is a continuing threat, and is compounded by anarchy in “ungoverned” states in the Middle East and Africa as well as the nuclear ambitions of North Korea and Iran. The rise of China and the expansionism of Russia create heightened risk of superpower conflict, after an extended period in which the U.S. was the dominant superpower. Consequently, defense and security spending is likely to rise in coming decades, making the peace dividend of the 1990s a distant memory.
“America First:” Trade was a dominant issue in the U.S. presidential campaign, and the expansion of trade is likely to reverse in coming years.
Valuations and public debt: Equity valuations were close to Depression-era lows in the early 1980s; valuations today are considerably higher, though below the peaks reached during the technology bubble. U.S. public debt to GDP was slightly more than 30% in 1980, giving Reagan considerable latitude to lower taxes. President Donald Trump has considerably less fiscal room to lower taxes unless he cuts spending elsewhere, as public debt is now more than 75% of GDP.
Economic growth was robust for most of the first two decades of the market rally. Real GDP growth averaged 3.6% from 1982 to 1989 and 3.2% during the 1990s. However, the 2000s featured two economic downturns, reducing real GDP growth to less than a 2% average for the decade. Asset manager Pimco coined the term “new normal” to describe an era of below-average economic growth. The 3 “Ds” – demographics, deficits and debt – make it likely that the new normal will continue as a long-term reality for economic and market growth. Consequently, investors should consider some important adjustments.
Revise economic growth and investment return expectations: Investors should reset expectations for returns, in a sense following the example set by pension funds that have lowered their expected rate of return on investments. Lowering return expectations doesn’t mean that returns will be negative, contrary to the more pessimistic predictions by analysts. The economy is still growing, as are corporate earnings.
Bonds may not be the only source of diversification for an equity portfolio: Government bonds were a great diversifier, dampening volatility while providing income and capital appreciation during equity market downturns. With interest rates at current levels, bonds won’t be as effective a diversifier. Bonds are likely to continue to be less volatile than stocks, but with lower income and capital appreciation potential the diversification benefit will be diluted. Many investors are supplementing their stock and bond portfolios with investments such as gold, managed futures, private real estate and insurance-linked securities.
Save more, while managing costs and taxes: In a low-return environment, investors may need to save a greater proportion of their earnings in order to reach long-term goals. In addition, managing costs and taxes can be the critical difference between investment success and failure. High-cost investments are easier to justify during periods in which double-digit returns are commonplace, but harder to absorb when returns are in low to mid-single digits. Managing the tax implications of investing may be equally important, as tax loss harvesting and a thoughtful approach to asset location are among the strategies that can enhance after-tax investment returns.
Find the right blend of active, passive and factor-based investments: Index and factor-based funds are low-cost, tax efficient options in many asset classes. However, index and factor-based funds aren’t necessarily the best solutions in all parts of the market. In some asset classes, index funds are arguably riskier than actively managed funds. Indexes are backward-looking, and bond indexes in many cases are constructed poorly. Most fixed income indexes have inherent flaws, “rewarding” companies and countries that issue the most debt. Equity indexes in more dynamic segments of the market, such as emerging markets, may have too little exposure to future growth opportunities. Blending active, passive and factor-based investments may provide superior returns to an approach that exclusively focuses on one style of management.