Wednesday, May 18, 2016

The New Global Economic Reality and the World of Diminishing Returns

A recent report by McKinsey Global Institute looks at the global forces that are changing the economy and how this will impact future decisions made by investors and how the returns on investments will change over the coming decades.  By looking at the performance of equities and bonds over the past three decades and longer, the authors of the report attempt to quantify total dividend and capital returns over the next two decades.  Here are some of their observations on how the returns on equities and bonds have behaved over the past three decades, how the relatively recent behaviour compares to past returns and the unique factors that have influenced these returns.  Before you dig into this posting, I want to apologize for its length; I summarized a report that was nearly 50 pages in length and have attempted to pick out the salient points that will help you better understand where we have been as investors and where we are heading.

Over the years between 1985 and 2014, returns on bonds and equities were far above long-term averages in both the United States and Western Europe as shown on this graphic:

It is interesting to see that, even with the impact of the 1987, 2000 and 2008 stock market collapses and the impact of the emerging market crisis in Asia during 1997, total returns to U.S. equity investors over the three decades between 1985 and 2014 were 1.4 percentage points or 21.5 percent higher than they were over the century between 1915 and 2014.  In the case of Western Europe, total returns to equity investors over the same three decade period were 3 percentage points higher or 61.2 percent higher than they were over the century between 1915 and 2014.  In the case of bonds, the return on U.S. bonds between 1985 and 2014 were 3.3 percentage points or 194 percent higher than they were over the century between 1915 and 2014.  In the case of Western Europe, total returns to bond investors over the same three decade period were 4.3 percentage points or 269 percent higher than they were over the century between 1915 and 2014.

What factors have driven these extraordinarily high returns on equities and bonds?   Let's start by looking at equities.  The authors' analysis's based on the aggregate returns of non-financial companies in the S&P 500 and looks at the following factors which interact with each other in a complex manner:

1.) aggregate revenue growth which is closely tied to GDP growth levels.

2.) cash returned to shareholders (i.e. as dividends or share buybacks) calculated as the company's earnings times a payout ratio.

3.) amount of earnings needed to be reinvested for future growth.

4.) inflation which impacts the ability of companies to distribute cash to shareholders.  High levels of inflation leads to lower price-to-earnings (PE) levels because companies have to invest more of their profits to achieve the same real profit growth.  For instance, PE ratios in the 1960s averaged between 15 and 16, dropping to between 7 and 9 in the 1970s as inflation rose substantially.  PE ratios rebounded in the 1990s to between 15 and 20 where they stand today.

5.) changes in real interest rates and their impact on interest expenses and interest income, a particular problem for highly leveraged companies.

Here is a graphic showing how declining inflation and growing margins as well as increasing net income margins have driven equity returns higher in the U.S. over the past three decades when compared to the past century and the past 50 years:

Declining inflation and increasing margins which have pushed up price-to-earnings ratios have been responsible for 2.5 percentage points of the gains in equity returns over the past thirty years.

For bonds, total returns have been impacted by the following factors which are relatively simple compared to those for equities:

1.) nominal interest rate yield.

2.) the movement of interest rates; bond prices rise as interest rates fall and vice versa, resulting in capital gains or losses for investors.

3.) inflation since investors expect a higher risk premium to compensate for anticipated inflation.

Here is a graphic showing how declining yields which have created higher capital gains (due to bond prices rising) and lower inflation have driven bond returns higher in the U.S. over the past three decades when compared to the past century and the past 50 years:

The return on bonds over the past three decades was pushed up by 1.8 percentage points alone thanks to declining bond yields.

Let's look at the five "exceptional" factors that have worked together to create the above-average returns environment for both equities and bonds over the past thirty years:

1.) Declining inflation:  Over the past 30 years, inflation has averaged 2.9 percent, down from an average of 4.3 percent over the past 50 years.  The turning point for inflation occurred in 1979 when the Federal Reserve raised interest rates to counter 13 percent inflation which declined to 3.9 percent in 1982.  In the United Kingdom, inflation hit 25 percent in 1975 and declined to 5.4 percent in 1982. As I noted above, inflation affects the payout ratio to equity investors; over the past 50 years, higher inflation has led to a payout ratio of 57 percent compared to 67 percent over the past thirty years of lower inflation.

2.) Declining nominal and real interest rates:  In real terms, global interest rates have declined by 4.5 percentage points between 1980 and 2015, largely related to declining inflation.  Demographics has also raised the propensity for savings and has resulted in a global savings glut which has contributed to lower interest rates.  Monetary policies thanks to the weak recovery since the Great Recession have sent interest rates in the U.S. and the United Kingdom to historic lows as you can see on this chart:

This has meant that U.S. companies have seen their net interest payments drop by 40 percent over the three decade period which has added one percentage point to their post-tax margins.  In addition, low interest rates can boost the prices of equities by lowering the discount rates (a measure of the present value of future cash flows) used by investors which results in an increase in PE ratios.  In addition, interest rate changes can impact share prices when investors rebalance their portfolios into equities, a move that pushes equity prices up when yields on bonds are at very low rates.

3.) World GDP growth factors:  Real GDP growth is one of the key drivers of equity returns.  Between 1985 and 2014, global GDP growth averaged 3.3 percent per year compared to 3.6 percent between 1965 and 2014.  In large part, over the past fifty years, global GDP growth was driven by two factors; demographics and productivity gains.  The rapid growth in the working age cohort (15 to 64 year olds or what are commonly known as the baby boomers) over the past fifty years has contributed 48 percent to GDP growth among the G20 nations.  For example, in the United States, employment grew at an annual rate of 1.4 percent over the past 50 years, a rate that is expected to drop by 0.3 percent over the next 50 years, pushing GDP growth levels in a downward direction.  Rising productivity contributed 52 percent to global GDP growth over the past 50 years with productivity in the U.S. rising by an average annual rate of 1.5 percent and productivity in Western Europe rising by an average annual rate of 1.8 percent over the five decade period.  This was largely because of the shift in employment from the low productivity agricultural sector to the more productive manufacturing and service sectors.  Here is a graph showing how per hour real output per person in the United States grew over the period from 1947 to the present on an annual basis, noting the continuous rapid growth from the early 1990s to the mid-2000s:

As well, integration of the world's economy through the signing of a number of key freer trade deals resulted in higher productivity.  

4.) Real estate prices:  As we are all aware, real estate price increases in some markets far exceeded their historical averages over the past 40 years, particularly in the 2000s.  Here is a graphic showing how real estate returns, measured using real home prices, varied by nation 1975 and 2014:

Real estate is one of the largest asset class in the United States; in 2014, real estate holdings totalled just over $34 trillion compared to $61 trillion in equities and bonds.  The most attractive aspect of real estate to some purchasers/owners has been the ability to borrow against it; this results in the perception of wealth which results in additional consumer spending, an important part of GDP.  Falling interest rates during the 2000s made it easier for home owners to borrow to purchase homes and to borrow against their existing home equity.

5.) Corporate profit margins:  Corporate profit margins have increased significantly over the past three decades, contributing one-third or 1.1 percentage points to the higher real equity returns when compared to the past 40 years.  In 2013, global after-tax operating profits rose to 9.8 percent of global GDP, up from 7.6 percent in 1980.  Global net income growth was also substantial, increasing its share of global GDP by more than 70 percent over the past thirty years.  This is largely because corporations were able to access the growing consumer class in major emerging markets like China and India.  At the same time, thanks to trade agreements, corporations were able to lower their cost base by accessing lower cost labor in the same emerging markets.

As you can see, each of these five unique factors are non-repeatable.  Short of heading into a deflationary environment, which leads to a whole series of negative economic consequences, inflation cannot fall as much as it has over the past forty years.  Interest rates have little room to fall except further into negative territory which could have a significant negative impact on the global economy.  Employment growth is unlikely to rise since the world's population is aging.  Businesses face an increasingly competitive environment now that they have exploited the world's largest and lowest cost emerging economies which will put downward pressure on profit margins and profits.  

Here is what the authors of the report expect for the future when it comes to equity and bond returns:

It is entirely possible that, given the end of each of the five aforementioned factors, equity and fixed income returns could be lower than the 50 or 100 year averages and will certainly be lower than the returns experienced from 1965 to 2014 and 1985 to 2014.  Chronically slower global economic growth or economic stagnation could push U.S. equity returns down by 250 basis points and bond returns by 400 basis points when compared to the three decade period between 1985 and 2014.  Even in a faster growth-recovery scenario, U.S. equity returns would be between 140 and 240 basis points lower and bond returns would be 300 to 400 basis points below the returns experienced between 1985 and 2014.

Many of today's investors have lived during the "golden age" of investing and have grown accustomed to equities and bonds yielding a certain level of return and have made the assumption (incorrectly, mind you) that past returns are indicative of future returns.  This analysis by McKinsey shows us that the higher than normal returns of the past thirty years can be attributed to the confluence of a series of non-repeatable events and that the changing face of the global economy means that we should be counting on far lower returns than we have come to expect.  This will have a significant impact on the retirement plans for millions of baby boomers who have counted on reasonable investment returns to fund their golden years and for their offspring who will find it more difficult to achieve returns that will allow them to save for their own retirements.


  1. I loved the apology and warning you gave early on that the article was a bit long. The task of relaying the information from a long report can be daunting however, you did so quite well. Predicting the future is even more of a challenge. The report you wrote about should give many economist pause.

    For sometime I have felt the current trends that have developed since the reset of 1979 have become unsustainable and that a new reset will occur at some point. If I'm correct it will be interesting to see how a future reset likely to involve a massive transfer of wealth will effect financial inequality. Below is an article containing such a scenario.

  2. One thing we have seen over the last 30 years in regards to trade deal is an acknowledgment of theses trends. The "Asian" shift by the US and the growth of the developing world is hoped to counteract the effects of developed worlds negative demographics and economic outlook.

    Old people are deflationary and young people are inflationary. That can also be said about economies. The large mostly youth populations of the Middle east, Indian sub continent, S. America, and Africa hold the future for global growth. Is it any surprise that Obama's Dream Act is all about getting more immigration of youth. Young people are far easier to be educated and ambitious within the economy.

    Is it any wonder that the US borders have been effectively under siege from a tidal wave of children coming to the US? This is not an accident. So what we are seeing in the global GDP and US is a shift to where the young people are. Go there or bring them here.