Each year, I put my head on the chopping block and publish a 30-year forecast for global stock and bond market returns. This forecast is used to create long-term asset allocation strategies for our clients.
It's a terribly imprecise exercise because no one can know how financial markets will perform in the future. There are just too many variables and too many unknowns. Yet here it is. So why do I risk professional suicide each year with an expected return forecast that's bound to be wrong? I do it because it's necessary.
A Necessary Exercise
Despite insurmountable head winds, we must plan. This means making assumptions about future risk and return even though we know the limitations of our assumptions. The idea of a well-constructed portfolio is to match current assets to future liabilities while controlling for risk. Yet the only known in this equation is the current asset level.
Estimates must be made about everything else; future deposits and withdrawals, asset class risk and returns, inflation, time horizon, liquidity, taxes, etc.
Antti Ilmanen writes in his comprehensive book Expected Returns: An Investor's Guide to Harvesting Market Returns: "We should humbly recognize the limits of our understanding. Realized returns are dominated by randomness, structural uncertainty, and rare events. Expected returns are unobservable, at best, estimated with noise. Any observed return predictability is mild, possibly spurious, and rarely robust."
Mean Reversion
We don't know much about the future, but we do know that others have opinions and that those opinions are reflected in market prices. We're also keenly aware that return expectations reflected in market prices are often far off the mark.
An asset class with recent high returns will draw the attention of many new investors who bid prices up on the expectation that returns will rise even higher. However, higher prices have to be supported with fundamentals, which fail to materialize. Prices then begin to fall, investors stampede out and returns collapse far below their historic average.
Recall the Nikkei in the 1980s, tech stocks in the 1990s, home prices in the 2000s and perhaps long-term bonds this decade.
In mid-March, a Zero Coupon Treasury Bond maturing in 2044 was priced to yield 2.43 percent. Since zero coupon bonds pay no interest, 2.43 percent is exactly what an investor will earn on their investment through the year 2044.
Does 2.43 percent tell us anything about interest rates except this is what investors in that bond expect to earn in the future? Will interest rates remain low for the next three decades? We can't know the answers from today's yield.
Forecasting is arduous, and we can't say much about the future. What we can say is that owning stocks is riskier than owning bonds and bonds are riskier than holding cash. Therefore, stocks should return more than bonds and bonds should return more than cash in the long run—most of the time.
Assumptions In The Forecast
Our 30-year total return forecast relies on five primary assumptions about financial market risk and return:
- Interest income, dividend yield, rents and other cash flows are an important part of total return
- Price volatility contains information about the trade-off between risk and return in the long term
- Investor perception of risk can change over time and this can affect current valuation and future expected returns
- Monetary policy changes investor preference for taking risk
- Fiscal policy and other political factors also change investor preference for taking risk
Don't Fight The Fed
One problem with assessing the returns of free markets is that they are never truly free. Artificial forces created by government policy are always in play. These factors can move capital among asset classes in a less than efficient manner.
Moreover, "monetary policy actions tend to influence economic activity and prices with a lag," according to a recent Federal Open Market Committee (FOMC) Statement on Longer-Run Goals and Monetary Policy Strategy. There is never true equilibrium in the system.
The U.S. and other developed nations have been practicing a policy of financial repression, whereby interest rates are held below the inflation rate. This helps government leaders finance spending and stimulate their economies, but it hurts the returns on fixed-income investments and pushes capital into riskier assets to find higher yield.
The result is an increase in the valuation of riskier assets, which decreases expected long-term returns.
It's widely anticipated that the FOMC will begin raising interest rates this year or early next year. In contrast, other central banks are going in the opposite direction by lowering interest rates through quantitative easing and even driving rates into negative territory.
All of this matters when forecasting long-term returns.