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.

Guess Who's Buying Equities

There is no doubt, the stock market has been on a tear over the past year as we can clearly see on this chart:

I was a frequent trader, particularly prior to and during the Great Crisis; my investment strategy in recent years has tended toward buying when others are selling I looked at the 2008 crisis as a buying opportunity, particularly for good quality preferred shares.  Right now, I don't like the market; it is frothy and, in my opinion, is not based on any fundamentals that I understand.  That said, apparently many investors would disagree with me and, in a hunt for return in this prolonged near-zero interest rate environment, desperation for yield reigns supreme.

What is most surprising is that one group of investors is increasingly turning to equities to boost the portfolios that they manage; central bank reserve managers.

Let's start by looking at what has happened to the trend in global central bank reserves since 1980:

Over the past ten years, total reserve holdings have risen by over 500 percent to approximately $11 trillion in 2013.  Official bank reserves are expected to increase from 29 percent of OECD government debt in 2011 to 38 percent by 2016 if current trends hold.  At this point, reserves amount to the equivalent of one-third of OECD bond markets.

A study by the IMF that polled 67 central banks around the world shows that over the past five years, reserve managers have had increasing difficulty with liquidity problems in their reserve portfolios with just over half of the 67 central banks expressing liquidity concerns.  As a result, nearly three-quarters of the reserve managers were forced to change their asset allocation by:

1.) reducing the level of commercial bank deposits.

2.) reducing their exposure to unguaranteed bonds.

3.) reducing their holdings of long-term AAA bonds.

This rebalancing of assets and low returns on bond portfolios has resulted in 31.8 percent of reserve managers in advanced economies exposed to equity markets and one in seven of those surveyed are investing in equities, an investment that was considered completely unacceptable for central banks just a few short years ago.  These managers are hoping that a rise in the value of their equity portfolios will offset a decline in the value of their bond portfolios as interest rates rise.   Interestingly, of middle-income nation central banks, only 8.7 percent are investing in equities and among low-income nation central banks, none are investing in equities.    

Let's look at an example.  A relatively large purchaser of equities is the Bank of Japan, holder of the world's second largest reserves.  On November 30, 2013, the BoJ held the following assets:

The Bank of Japan held ¥1.360 trillion ($13.33 billion) in stocks, ¥2.419 trillion ($23.7 billion) in index-linked ETFs and ¥139 billion ($1.36 billion) in real estate investment trusts out of total assets of ¥224.1 trillion ($2.197 trillion).  At the end of 2009, the Bank of Japan held only stocks with a value of ¥1.335 trillion and no equity ETFs or REITs.  Obviously, the Bank of Japan is like the rest of us; seeking yield.  Back in April, the Bank announced that it will pump an additional $1.4 trillion into Japan's economy over the next two years through asset purchases.  Over that period, it will be doubling its investments in equity exchange-traded funds.

Other central banks that invest in equities include the Swiss National Bank (SNB) which states the following on its website:

"The equity portfolios are made up of shares from medium-sized and large corporations in advanced economies. The SNB takes care to ensure that its equity management, too, has no impact on the markets. Furthermore, it does not regard itself as a strategic investor. Thus, equities are managed passively and according to a set of rules, and on the basis of a strategic benchmark comprising a combination of equity indices in various currencies."

Nowhere on its website, could I find the actual size of the SNB's equity portfolio although according to Bloomberg, in the first quarter of 2013, the SNB had about 15 percent of its assets held in passive funds that track equity indices.  Other central banks with substantial equity investments include the Bank of Israel, the Czech National Bank and the Bank of Korea.

It is interesting to see that low returns on bonds have changed how even the most conservative central bank reserve managers invest.  Low returns are forcing both individuals and central bank reserve managers to invest in riskier and more volatile asset classes.  Even though central banks state that they are passively investing in equities, the message that is being sent to retail and wholesale investors can easily be misconstrued, leading to unintended upward pressure on equity prices, something that the world's stock markets may be experiencing right now.

It's all part of the signals that the world's central banks are sending to the so-called "free market".