Stock markets’ 30-year sweetspot under serious threat
The prospect of lower returns on equities creates real dangers for retirement plans
The past 30 years are often seen as a bad time for investors. The period saw two epic market breaks in the US, with the bursting of the dotcom bubble in 2000, and the credit bubble seven years later; the collapse of the Japanese stock market in 1990, from which it is yet to recover; and a severe recession following the credit crisis.
So it is disconcerting to be warned by the McKinsey Global Institute that the past 30 years have been a boon for markets that cannot be repeated. US stocks have averaged growth of 7.9 per cent over the period, which is ahead of the 6.5 per cent average for the past 100 years.
McKinsey now suggests that growth of only 4.0 per cent over the next 20 years is possible.
European equities have gained 7.9 per cent per year for 30 years, compared to an average for the last century of 4.5 per cent. Bonds, of course, have been in a bull market for the last three decades, which cannot continue much longer.
Several factors made the past three decades so good. The cold war ended, China emerged, and the world enjoyed a demographic sweetspot as postwar baby boomers made and spent money.
Converting these factors into drivers of stock market performance, Richard Dobbs of the McKinsey Global Institute lists at least four that cannot be repeated.
Inflation has been tamed
In 1985, Paul Volcker was running the US Federal Reserve, and single-digit inflation was still not to be taken for granted. Now that inflation has been tamed, it cannot be tamed again — unless serious inflation returns, which would be disastrous for asset prices in the short term.
Interest rates have fallen
This one-off adjustment cannot continue to boost asset prices. From now, either interest rates will stay flat, meaning a low-return world, or they will rise, inflicting a short-term capital loss.
This week’s very negative response to the Bank of Japan’s decision not to cut rates, when there had been talk of cutting rates further into negative territory, shows that hope that ever-lower interest rates could power ever-rising share prices had lived on. It is hard to justify.
The economy has grown
Thanks to a rise in employment, driven by demographics, and to rising productivity, economic growth averaged 3.5 per cent per year over the past three decades, in the US and western Europe. Now, with fertility falling, the prospects for growth are far more constrained. Japan, where gross domestic product per capita has risen, but whose declining population has meant growth insufficient to push up asset prices, suggests what might happen.
Corporate profitability rose
A huge increase in the global “consuming class” from about 1bn to 2.5bn over the period, combined with the arrival of the internet to keep control of costs. Tax rates and interest rates fell, leaving more money for corporate profits.
Now, these factors could turn negative. The internet, through “disruption” becomes a threat to profits — think of the companies damaged so far by the rise of Amazon and Google. And emerging markets are spawning stronger multinational companies and could turn into a source of competition.
McKinsey’s convincing list explains why we had it so good in the past 30 years — even if excitement caused markets to melt up and overshoot — and why we should be braced for lower returns in future. Based on reasonable assumptions, they suggest a “best case” of 6.5 per cent equity returns for the US over the next 20 years, or only 4.0 per cent if growth is slow as feared.
For Europe, its projection is between 5 and 6 per cent.
Pensions are under enough pressure as it is. Risk has been pushed back to individuals, through 401(k) plans, personal pensions and the like, while those public bodies and big corporations still guaranteeing an income to their members face large and mounting deficits. And yet many assume equity returns of 7 per cent.
What would it mean for returns to fall short of this by three percentage points in the US, as McKinsey warns is possible? For a 30-year-old millennial starting to put money into a pension, those three percentage points mean needing to work an additional seven years to get the same pension — or having to pay more than twice as much into their pension. And for US public employee pension plans, the three percentage points could more than double their deficit, from $1tn to $2.5tn.
Solutions would involve investing in something other than public equities. But what exactly is going to deliver the returns? It is hard to persuade institutions into infrastructure, while hedge fund strategies, some of which are not correlated to equities, come with high fees against which some large pension funds are now rebelling. For individuals there is little or no way to gain access to such asset classes in any case.
So the risk that many end up unable to sustain themselves in old age is real and growing. And not only McKinsey has worked that out. Anxiety about the financial future has spurred much of the current interest in political populism. That anxiety is well founded.