Accepting Average: The Likelihood of Mediocre Future Returns
Over the last 10+ years, U.S. equity outperformance has been caused by increased profit margins, the accretive impact of share buybacks, dollar weakness, and most significantly, an outsized expansion in equity multiples. There are risks to all of these sources of outperformance, suggesting that a neutral long-term strategic allocation to U.S. equities is now likely warranted. Investors should expect meaningfully lower absolute returns from U.S. stocks over the next decade than what they have earned in recent years/decades, barring a continued rise in an already stretched profit margin. A structurally overweight stance is still warranted toward equities versus fixed income, but even a 100% equity allocation is unlikely to meet investor return expectations in the high single-digits. This argues for greater tolerance of volatility and the pursuit of riskier investments and asset classes such as real estate and other alternative investments as potential portfolio return enhancements.
Multiple expansion has been evident in heavily-weighted consumer discretionary, information technology, and communication services sectors. Higher interest rates on a structural basis may cause outright multiple contractions for U.S. stocks. This is particularly true for growth stocks, which have been responsible for a significant portion of U.S. equity outperformance, given their comparatively long earnings duration.
The Current Situation
The investment climate promises to be much more challenging over the next ten years than in recent decades. Stocks, bonds, real estate, and most other assets have benefitted enormously from the persistent decline in interest rates since the early 1980s. The era of declining interest rates is over, barring a slide into global deflation that would be disastrous for the prices of risk assets. The current rich valuations for most asset classes represent a significant headwind for real returns over the next decade. Asset prices already discount a rosy future.
Inflation is the most significant wildcard for the long-term return outlook. Current bond yields are consistent with investor confidence that the recent increase in inflation will be transitory. Such complacency is misplaced. A replay of the high inflation of the 1970s is not on the horizon. Still, we expect inflation to be higher, more persistent, and more problematic than most investors and policymakers anticipate. It will be on investor radar screens for years to come.
For a conventional multi-asset portfolio consisting mainly of stocks and bonds over the next ten years, the most likely scenario is that global growth will be solid but accompanied by somewhat higher underlying inflation. In such a base-case scenario, interest rates would rise over the next decade, leading to poor absolute real portfolio returns along with greater volatility. Real bond returns would be poor, and a valuation de-rating would significantly offset the benefits of healthy economic growth to risk assets. The overall returns and risk-reward on balanced portfolios would be considerably less favorable than has been the case for most of the past four decades. To an extent, the next decade will result in some payback for the generous returns of the past few decades of falling interest rates. An optimistic scenario would be for government bond yields and corporate earnings to rise modestly amidst decent global economic growth and low inflation. In such a scenario, current valuations would be sustained, government bonds would generate only moderate negative real returns, while equities would produce mid-single-digit real returns. A 60/40 equity/bond portfolio would deliver less than stellar real returns by current standards, but not dismal either.