Don’t Bank On Exceptional Future Equity Returns

Credit Suisse Research Institute has just launched its Yearbook which takes an in-depth look at various asset class returns over a prolonged timescale, after all, the longer the dataset the greater the probability of discerning trends. It reveals some interesting observation regarding the past and so extrapolations of future returns for bonds, cash, and equities.

According to the authors, which include not only Credit Suisse’s in house analysts but also external contribution from the London Business School, the investment landscape has changed and the typical expectation of 6% or 7% annual returns that investors mentally anchor themselves to are now outdated and very likely to be an overestimation of future returns.

The study is extremely well documented with a plethora of data, charts and convincing arguments and is somewhat worrying for actuaries in particular as it indicates a real need for change in the assumptions that underlay many a pension expectation. If the historic high-returns of the last 30, 40, or even 60 years were sufficient enough for the baby boomers to have their deserved pension, the current low-return era which commenced in 2000 may bring a new challenge to us and our children and very likely leave many in penury.

The average annual real rate of return for global equities since 1950 was 6.8% and 6.4% if we take the period from 1980 until today. Global bonds also benefitted from excellent returns in the period amounting to 3.7% and 6.4% respectively – the latter period of course coinciding with the great secular bond bull market that is arguably now at its end.

Taking the thirteen years of the new century, equities have risen at a dismal rate of 0.1% per year with bonds in contrast at 6.1%. Of course the very poor equity return is a consequence of the very extended valuations at the end of the last millennia. Bond yields have decreased sharply in recent years as the financial crisis led investors to safe havens and QE in the US and UK in particular depressed bond yields to artificially low levels. This has, empirically it seems, also provided a serious shot in the arm for equities. The exceptional real returns that ran throughout the entire twentieth century is now probably, excuse the pun, a thing of the past.

In the medium term (10-20 years) with the heavy debt overhang in Western economies and the fairly valued equity levels at present, there is very little reason to expect exceptional “real” returns. Of course nominal returns are different as if the nuclear button is pressed on money printing then equities could shoot, in nominal terms, dramatically higher. With regards to bonds, then this is likely to be a massive underperformer and wealth destroyer over such a timescale.

Currently, the real yield on bonds for 20 year maturities from countries with virtually no default risk are near zero as prices have risen to elevated levels with investors seeking supposed “safe” assets. In fact recently, investors have been willing to accept negative real interest rates simply to park their money in German and Swiss bonds for example – an extremely odd state of affairs!

The quest for safe havens combined with central bank intervention / manipulation may explain the current low-yield environment and factors distorting the market. Many believe that when these distorting issues disappear that the markets will return to normality. That however os not the opinion of the authors of the Yearbook. They believe all those factors are already priced in (I suppose still putting faith into EMH – Efficient Market Hypothesis) and the market is quite simply overestimating future real rates of return.

Equity returns are, according to financial theory, equal to the risk free rate (return ironically, the US T-bill is used – even though they are the most heavily indebted nation on earth and probably effectively insolvent) plus an equity premium. All things being equal, a low real interest rate world must produce a lower-return world for equities, as the risk free component is of course lower. According to the authors, the higher the current real interest rate, the higher future returns are. So, with the current almost non-existent real return rates, subsequent returns should be expected to be low.

Instead of the usual estimate of around 6%-7% for the average equity premium, the Yearbook expects it to be more within 3 to 3.5% range.

The findings and statements made in the Yearbook, translate into an expected real rate of return for a 20 year bond of, wait for it, around -0.5% and, for the 30 year bond, zero. Adjusting for equities, we have an expected real rate of return of 3% to 3.5% – pretty much half of what the 20th century delivered

The assessment made in the Yearbook may of course prove to be wrong in the future if the current market conditions lead to higher interest rates – a factor that will be very negative for current bond buyers and very likely lead to a new crisis! The FSA in the UK stipulates projections of 5%, 7% & 9% before costs for a notional product invested two-thirds in equities and one-third in fixed income. But, with the current environment, the FSA just reviewed those rates down to 2%, 5% & 7% – much lower rates in keeping with the results of these studies.

These low rates of course increase pension liabilities which are estimated at GBP 1 trillion in the private sector and GBP 4.3 trillion in the public sector. With such deficits, there may be a need to increase the UK national insurance, the pension age, and/or to cut the benefits – precisely the path that the current Government is pursuing and that is constraining economic growth in the UK.