Are We Really Facing a "Purgatory" of Low Returns?
One of the things I admire about famed "permabear" Jeremy Grantham and the asset management firm he founded, Grantham, Mayo, & Von Otterloo (GMO), is their commitment to putting forecasted future returns for different asset classes right out there in the public square, so to speak. Recently, Grantham made headlines with his latest call for a reversion to the mean from today's "superbubble" in financial assets, which he describes as the "most dangerous breadth of asset overpricing in financial history."
But what may be even more concerning is GMO's predictions for how capital markets will behave over the longer term.
Per GMO, only two of 11 asset classes will earn investors positive returns over the next seven years – both in emerging markets. Large-cap U.S. equities are expected to be the worst performers, with a return of -7.3%. U.S. bonds won't provide a safe haven, with an estimated decline of -4.1%. Even cash will lose the race against inflation, with a forecasted return of -1.1%.
Grantham and GMO have been famously wrong before. But if they’re even a little bit right, that would be very bad news for the modern global system of financial capitalism. So much of our daily lives and the organizations we belong to and rely on are leveraged to positive real returns on financial assets. Pension funds, for example, are designed around the premise of long term returns. Universities, schools, museums, hospitals, count on drawing on their endowments into perpetuity to supplement their earned income. Individual defined contribution accounts, now the primary retirement savings vehicle for most Americans, don't serve their purpose if investment returns don't outpace increases in the cost of living (including healthcare). The operating models underlying all of those assume positive real returns. And for the last decade, since the Great Financial Crisis, capital markets have delivered. Big time.
Last week's heightened market volatility further underscores the consensus concern that those recent returns haven't been driven as much by fundamental economic growth but instead by artificially low interest rates and easy access to capital (the result of accommodative monetary policy and stimulative fiscal policy,) which have in turn boosted valuation multiples to the point where they are "largely flashing red" (as my colleagues at Strategas wrote this week). Large-cap equities, as an example, are trading at more than 22x forward earnings, a level from which, historically, the next five years of nominal performance has averaged only 1.7%. As the Fed begins to raise interest rates and moves from buying bonds to shrinking its balance sheet, the proverbial music may be about to stop.
I take some solace from an article of GMO's former gurus, James Montier, wrote entitled "The Purgatory of Low Returns." In it, he bemoaned "This might just be the cruelest time to be an asset allocator. Normally we find ourselves in situations in which at least something is cheap... However, today we see something very different... today's opportunity set is characterized by almost everything being expensive... this is a direct effect of the quantitative easing policies being pursued by the Federal Reserve and their ilk around the world."
Does that sound like what we're hearing today? Well... the date of that article is 2013.
Since then, the MSCI U.S. index has delivered an annual rate of return of over 16%. More typically diversified investment portfolios have also delivered strong returns over that same time period, well above the 7% required to fund operating draws and grantmaking activities and preserve portfolio principal.
The consensus forecast may be for single digit equity returns this year, but as Strategas CEO Jason Trennert notes, "That doesn't actually happen all that often". Only three times in the past 13 years, in fact. Longer-term forecasts are even more suspect.
Short of trying to time the market, which is a fool's undertaking, the best defense against low future returns may just ultimately be banking the positive returns you've generated in the past – which have been plentiful – and counting on them, as individual investors and societally, to get us through the lean years we might be about to face.