Diminishing Investment Returns: Why Investors May Need To Lower Their SightsVW Staff
Diminishing Investment Returns: Why Investors May Need To Lower Their Sights by McKinsey & Co
Buoyed by exceptional economic and business conditions, returns on US and Western European equities and bonds during the past 30 years were considerably higher than the long-run trend. Some of these conditions are weakening or even reversing. In this report, we attempt to quantify the impact on future investment returns. Our analysis suggests that over the next 20 years, total investment returns including dividends and capital appreciation could be considerably lower than they were in the past three decades. This would have important repercussions for investors and other stakeholders, many of whom have grown used to these high returns.
- Despite repeated market turbulence, real total investment returns for equities investors between 1985 and 2014 averaged 7.9 percent in both the United States and Western Europe. These were 140 and 300 basis points (1.4 and 3.0 percentage points), respectively, above the 100-year average. Real bond returns in the same period averaged 5.0 percent in the United States, 330 basis points above the 100-year average, and 5.9 percent in Europe, 420 basis points above the average.
- A confluence of economic and business trends drove these exceptional investment returns. They include sharp declines in inflation and interest rates from the unusually high levels of the 1970s and early 1980s; strong global GDP growth, lifted by positive demographics, productivity gains, and rapid growth in China; and even stronger corporate profit growth, reflecting revenue growth from new markets, declining corporate taxes over the period, and advances in automation and global supply chains that contained costs.
- Some of these trends have run their course. The steep decline in inflation and interest rates has ended. GDP growth is likely to be sluggish as labor-force expansion and productivity gains have stalled. While digitization and disruptive technologies could boost margins of some companies in the future, the big North American and Western European firms that took the largest share of the global profit pool in the past 30 years face new competitive pressures as emerging-market companies expand, technology giants disrupt business models, and platform-enabled smaller rivals compete for customers.
- As a result, investment returns over the next 20 years are likely to fall short of the returns of the 1985–2014 period. In a slow-growth scenario, total real investment returns from US equities over the next 20 years could average 4 to 5 percent—more than 250 basis points below the 1985–2014 average. Fixed-income real returns could be around 0 to 1 percent, 400 basis points lower or more. Even in a higher-growth scenario based on resurgent productivity growth, we find that returns may fall below the average of the past 30 years, by 140 to 240 basis points for equities and 300 to 400 basis points for fixed income. Our analysis shows a similar outcome for Europe.
- Most investors today have lived their entire working lives during this golden era, and a long period of lower returns would require painful adjustments. Individuals would need to save more for retirement, retire later, or reduce consumption during retirement, which could be a further drag on the economy. To make up for a 200 basis point difference in average investment returns , for instance, a 30-year-old would have to work seven years longer or almost double his or her saving rate. Public and private pension funds could face increasing funding gaps and solvency risk. Endowments and insurers would also be affected. Governments, both national and local, may face rising demands for social services and income support from poorer retirees at a time when public finances are stretched.
Over the past 30 years, financial investors have had to contend with two equity market collapses, in 2000 and 2008; the steepest one-day decline in history on the New York Stock Exchange, in 1987; an emerging-market crisis that erupted in Asia in 1997 and spread to Russia and Brazil in 1998; and a worldwide financial meltdown and banking crisis. Despite these challenging episodes, financial markets in the United States and Western Europe still delivered total investment returns to investors between 1985 and 2014 that were considerably higher than the long-term average.
These returns were lifted by an extraordinarily beneficial confluence of economic and business factors, many of which appear to have run their course. Consequently, investors may need to adjust their expectations downward.
In this report, we discuss the changing economic and business conditions that will determine the future investment returns earned by US and European equity and fixed-income investors and attempt to size the magnitude of the potential shift. Our analysis finds that even if GDP growth rates were to return to the trend rate of the past 50 years, other factors could dampen annual returns over the coming decades by 150 to 400 basis points compared with returns earned in the past 30 years.1 We also discuss what it would take—such as sweeping technological change that lifts corporate productivity and profit growth—to bring returns back to the same level investors enjoyed between 1985 and 2014.
This report has several important caveats. First, we model investment returns only on US and Western European traded equities and bonds. For reasons of simplicity, we exclude performance of real estate and alternative investments. We also do not assess the past or future performance of emerging-market investments. All of these could lift average returns for investor portfolios in the years ahead, and indeed in future iterations of this work we may expand our analysis to include them. Finally, the analysis in this paper is not meant to be a forecast of future equity or bond returns. Our goal is to help investors, governments, and individuals understand the drivers of returns and the trends that could dampen future investment performance, the potential magnitudes involved, and their implications, so that they can reset their expectations.
1985 To 2014 Was A Golden Era For Investment Returns
The period from 1985 to 2014 produced equity and bond returns far above long-term averages for both the United States and Western Europe (Exhibit 1).
Real total returns on US and Western European equities both averaged 7.9 percent. In the United States, this was 140 basis points above the 100-year average and 220 basis points higher than the 50-year average. Western European equity returns in the 1985–2014 period also exceeded the 100-year and 50-year averages, by 300 and 220 basis points respectively.
Fixed-income investments, as measured by total real investment returns on government bonds, were also considerably higher on both sides of the Atlantic in the 1985–2014 period than they had been in 1915–2014 and 1965–2014. Total real US government bond returns of 5 percent were 330 basis above the 100-year average and 250 basis points above the 50-year average, while real returns on European bonds averaged 5.9 percent, which was more than triple the 100-year average and 150 basis points above the 50-year average.
Most investors today have lived their entire business and professional lives during this golden era and many have grown used to expecting that future investment returns will match those of the past. Many public pension fund managers in the United States, for example, assume returns on a blended portfolio of equities and bonds of about 8 percent in nominal terms, which corresponds to about 5 to 6 percent in real terms.3 With a portfolio of 70 percent of assets in equities and the remainder in fixed income, and assuming real fixed-income returns of 2 percent going forward, this implies that expectations of real equity returns could be 6.0 to 7.5 percent.
This era is coming to an end, as the factors that have contributed to the higher investment returns in the past run out of steam. To understand this, we need to start by examining what has driven
the extraordinary investment returns of the past three decades.
Identifying Drivers Of Equity And Fixed-income Returns
Generations of investors have sought to identify the factors that drive equity and fixed-income investment returns. In the investing and economic literature, debate continues over the degree to which equity and fixed-income markets are efficient and rational or unpredictable and emotion-driven.4 Researchers and institutional investors seeking to estimate equity investment returns in the near and long term use a variety of approaches, and there is a growing body of literature on the topic.
One approach often used for equities is to calculate a long-run average equity return (such as over the past 100 years), and use this to estimate a historical equity risk premium, as the average return minus a risk-free rate. It is then possible to estimate future investment returns based on projections for the equity risk premiums and the risk-free rate (typically taken as prevailing interest rates on government bonds). An alternate approach uses a discounted cash flow model, with equity investment returns calculated based on assumptions for GDP growth, inflation, dividend yields, and price-to-earnings (PE) ratios. This approach typically requires assumptions to be made on variables such as dividend yields or PE ratios (which are not directly economic and business variables).
Our approach in this report differs from these other approaches, although our findings are consistent with some. We build on the discounted cash flow approach, but we directly link investment returns on equities and fixed income both to the real economy and to business fundamentals. Our approach lays out a detailed analytical framework by which to quantify future investment returns on these investments. We believe this can serve as a tool for investors to analyze investment returns under alternate conditions in the economy.
For bonds, the essential elements of total investment returns are yield to maturity and capital gains or losses driven by changes in the yield to maturity (Exhibit 2). Interest rates are a critical element determining price: after the bond is issued, the bond’s price changes as interest rates fluctuate, rising as prevailing interest rates fall and vice versa. This results in capital gains or losses for the bondholder. The movement of interest rates is determined by many factors, including supply of and demand for credit, actions by central banks, changes in credit risk for both governments and corporations, and changes in investor risk appetite. Higher inflation has an impact on fixed-income investment returns by raising nominal interest rates, but it affects the real yields on bonds.6 Investors demand a risk premium to compensate for expectations of inflation in the future, but realized inflation may be lower or higher than expected. This mismatch between expected and realized inflation partially explains the sustained decline in real interest rates since 1985.
Equity investment returns are explained by a more complex set of factors that are also underpinned by economic and business fundamentals. The two direct components of total equity investment returns are, similarly to bonds, price appreciation and a cash yield, which is the cash returned to investors in the form of dividends and share repurchases as a percentage of the value of equities at the beginning of the measurement period (Exhibit 3).7 Price appreciation is determined by a company’s earnings growth (based on growth in revenue and change in1 profit margins), and changes in the price-to-earnings (PE) ratio. Changes in the PE ratio 1reflect changes in investors’ expectations of future earnings growth, return on equity, inflation, and the cost of equity (see the Technical appendix for a more detailed discussion1 on how PE ratios depend on these variables).
Our analysis of the US equity market is based on the aggregate investment returns of non-financial companies in the S&P 500, meaning the sum of all the companies in the index using financial metrics from McKinsey’s Corporate Performance Analytics database.8 Aggregate revenue growth is closely tied to GDP growth, although in some periods aggregate revenues may grow faster or slower than GDP growth. The cash returned to shareholders is the companies’ earnings times a payout ratio, which is simply the portion of earnings not needed to be reinvested in the business to drive future growth. The amount of earnings needed to be reinvested for future growth is, in turn, determined by nominal growth and the marginal return on equity. All else being equal, when companies earn a higher return on equity, they do not need to invest as much to achieve a given level of growth. Conversely when companies grow faster they need to invest more of their earnings at a given return on equity and will have lower payout ratios.
Inflation has an important, but under-appreciated effect on equity investment returns, affecting both payout ratios and PE ratios. Higher inflation increases nominal net income growth, which in turn reduces the payout ratio and the cash returned to shareholders, unless companies are able to increase their return on equity sufficiently to offset the effect of higher nominal growth on required investment.9 During the high inflation of the 1970s and early 1980s, firms were not able to increase their prices and profit margins enough to compensate for the higher reinvestment rates required. In addition to reducing cash distributions, high inflation also reduces PE ratios. During periods of high inflation, investors increase the nominal interest rates on fixed income investments. To maintain the relative attractiveness of equities versus fixed income investments, investors also increase the nominal discount rates that they use to value companies’ future cash flows. At the same time, investors lower their cash flow expectations because of the lower payout ratios we just described.
Changes in real interest rates can also affect the value of equities and, therefore, equity investment returns. One effect is on interest expense and interest income. Higher real rates lead to higher interest expense and lower interest income. For companies with modest leverage, these effects are not significant. In theory, changes in real interest rates could also affect the real cost of equity (the discount rate investors use to discount expected future cash flows from companies). As we discuss later, however, the empirical evidence does not show that changes in real interest rates have measurable effects on the real cost of equity.
Equity And Fixed-income Returns Over The Past 30 Years Were Lifted By Falling Inflation, Declining Interest Rates, Strong GDP Growth, And Even Stronger Profit Growth
Some of the differentiating factors for investment returns are most clearly identified by looking at the difference between total fixed-income and equity investment returns over the 30 years between 1985 and 2014 and comparing them with investment returns from the 50 years between 1965 and 2014.10
The most important factor for US ten-year government bonds were the large capital gains driven by declining interest rates in the past 30 years. Capital gains accounted for 1.8 percentage points of the 2.5 percentage point difference between 30-year and 50-year investment returns. Inflation that was lower than expected contributed an additional 1.3 percentage points. These factors were diminished by the change in nominal yields over the two periods (Exhibit 4).
The same factors affected Western European fixed-income investment returns. For UK ten-year government bonds, for example, real investment returns in the past 30 years amounted to 4.9 percent, compared with 2.5 percent in the past 50 years. Of the 2.4 percentage point difference in real investment returns between the 30-year and 50-year return, higher nominal capital gains in the 30- year period contributed 1.6 percentage points, while lower inflation contributed an additional 2.4 percentage points. Higher nominal yields in the 50-year period shaved some of the impact from these gains, by 1.5 percentage points.
For equities, changes in price-to-earnings ratios, which reflect investor expectations of future real profit growth, inflation, and return on equity, played a decisive role in lifting investment returns over the past 30 years. The difference in average real equity investment returns between the 30 years from 1985 and 2014, and the 50 years from 1965 to 2014 amounts to 3.3 percentage points (Exhibit 5). Differences in the PE ratio pattern between the two periods accounted for 2.5 percentage points of the difference. PE ratios were roughly the same at the beginning and end of the 50-year period. However, during the 30-year period, forward PE ratios increased from an average of 10 between 1982 to 1984 to an average of 14.8 between 2012 and 2014. In 2014, forward PE ratios stood at 17. Growth in profit margins in the past three decades accounted for 1.1 points of the increase in equity investment returns. Slightly higher real GDP growth in the 50?year period contributed to higher 50-year investment returns by 0.3 percentage points.
The increase in PE ratios in the recent 30-year period reflects a rebound since the 1970s, a period of double-digit inflation. During the 1960s, PE ratios on US equities averaged between 15 and 16 for the market overall. However, in the mid-1970s, they plunged to between 7 and 9, largely due to high inflation. As we discussed in the previous section, high inflation leads to lower PE ratios as investors reduce their cash flow expectations because companies have to invest more of the profits to achieve the same real profit growth, thus generating lower cash flows. Also, investors demand higher nominal investment returns to offset their concern about the declining purchasing power of future dividends, increasing nominal discount rates. By the early 1980s, PE ratios had recovered only slightly, to about 10, as investors were still concerned about high inflation even though actual inflation had begun to subside. Continued declining inflation eventually convinced investors that inflation had been
wrung out of the system. In addition, aggregate profit margins continually improved during the 30-year period, leading to higher cash payout ratios.
As a consequence of these favorable trends, PE ratios rebounded, rising to a range of 15 to 20 times earnings in the early 1990s, roughly where they stand today.11 This increase of PE ratios from the 1980s to today’s levels had an outsized impact on equity investment returns over the past 30 years. As noted, the conditions at the start and end of the 50-year period were relatively “normal,” and this is reflected in the PE ratios in the 1960s and PE ratios today, which have been in the range of 15 to 20.
Four Exceptional Factors Underpinned The Above-average investment returns
As we have seen from the exhibits above, four factors—inflation, interest rates, real GDP growth, and corporate profitability—constitute the fundamental economic and business conditions underpinning equity and bond investment returns. Assessing what explains their past trends, and how this may shift in the years ahead, is critical for assessing future medium- and longterm market trends.
Inflation Has Declined Sharply Since Its Peak In The Late 1970s
The three-decade decline in US and European inflation since the oil shocks and easy monetary policy of the 1970s has had a significant beneficial impact in financial markets. In the United States, consumer price inflation averaged 2.9 percent over the 30-year period, considerably less than the 50-year inflation average of 4.3 percent.
The turning point for inflation came in 1979, when the Federal Reserve under the chairmanship of Paul Volcker raised interest rates aggressively to bring down inflation, which had risen above 13 percent. By 1982, US annual inflation had fallen to 3.9 percent and stayed at about 4 percent through the rest of the 1980s. European central banks took similarly aggressive action to rein in inflation. In the United Kingdom, inflation reached 25 percent in 1975 but declined to 5.4 percent by 1982. Inflation in France reached 15 percent in 1974 but dropped to 4.7 percent by 1985 and has been subdued ever since. German inflation never reached the same heights as those of its large European neighbors, but it also dropped sharply, from more than 6 percent in 1981 to about 2 percent in 1984.
German reunification in 1990 led to a renewed bout of inflationary pressure, with consumer price inflation rising in 1992, but the Bundesbank responded quickly by raising interest rates. Since the 2008 financial crisis, inflation has dipped further, and particularly in Western Europe it has dropped so low as to stoke concerns about the risks of deflation.
As discussed above, inflation affects real equity investment returns through the payout ratio and its effect on PE ratios. Higher inflation over the past 50 years led to a payout ratio of 57 percent, compared with 67 percent over the past 30 years. The low PE ratios of the 1970s and 1980s were a direct consequence of the high inflation investors had come to expect, and the subsequent rise in PE ratios was the biggest contributing factor to the high equity investment returns of the past 30 years. The net cash yield to shareholders was roughly the same in both periods, at about 4 percent, as lower payout ratios and lower PE ratios largely offset one another (for more details, see the Technical appendix).
For fixed-income investment returns, capital gains from declining nominal interest rates were a key contributor to higher investment returns in the past 30 years. Falling inflation explains part of this decline in nominal rates but it was also due to a decline in real interest rates after central banks brought inflation under control in the 1980s and helped reduce investors’ inflation risk premium.12
Falling Investment, Higher Savings, And Central Bank Action Reduced Interest Rates, Which Are Now Negative In Some Countries
Global nominal and real interest rates, which have a direct bearing on bond prices and also affect equities, have declined since the 1980s. Central banks first tamed inflation, and then the propensity to save rose while the global investment rate fell.13 Since the 2008 financial crisis, central banks have used rates and other unconventional monetary policy instruments in attempts to rekindle economic growth. In the United States, the rate on nominal ten-year US Treasury bonds fell from about 14 percent in 1981 to 2.2 percent at the end of 2015; it stands at 1.9 percent as we write this report. In the Eurozone, nominal interest rates on ten-year government bonds declined from 14.6 percent in 1981 to 1.3 percent in 2015, according to the Organisation for Economic Co-operation and Development (OECD).14 In the United Kingdom, nominal interest rates of ten-year government bonds declined from above 13 percent in the early 1980s to 1.9 percent in 2015.
Some researchers have estimated that, in real terms, global interest rates declined by 4.5 percentage points between 1980 and 2015.15 For mature economies, prior MGI research has shown that real interest rates on ten-year government bonds declined from between 6 and 8 percent in the early 1980s to 1.7 percent in 2009.16 Declining inflation explains the early part of the fall. As inflation stabilized, the perceived risk of unexpected future inflation also decreased, driving down inflation risk premiums.
Other factors have contributed to the decline in interest rates. Favorable demographics, which increased the share of the working-age population and reduced the dependency ratio, may have raised the propensity for savings, especially in China.17 The consequential sudden and massive inflows of savings from emerging markets into US and other financial markets, the so-called global saving glut, contributed to lower interest rates.18 The falling relative price of capital goods and a reduction in public investment contributed to lower demand for capital, which in turn reduced pressure on interest rates.19 Demand for capital also fell with investment. Investment as a share of GDP fell from 24 percent of US GDP in 1985 to 20 percent in 2015.
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