The Downfall Of Equity & Fixed Income: Do Investors Need Alternative Assets?

For large North American and Western European companies the past 30 years have been a golden age.

Emerging markets consumers, cost cuts through automation, global supply chains, falling corporate taxes and falling interest rates, declines in inflation, and rapid growth in China strongly boosted revenues.

Now, however, competitors from emerging-market companies and small and medium-size platform-enabled companies have brought that era to an end.

What does that mean to large-scale institutional investors who took the largest share of the global profit pool? What are the prospects for future returns?

Equity And Fixed-Income Not Likely To Reach Past Levels

Returns from stocks and bonds will most probably be much lower over the coming two decades, resulting in painful repercussions for private and institutional investors, pension funds and governments around the globe.

According to the McKinsey Global Institute (MGI) report “Diminishing Returns — Why Investors May Need To Lower Their Expectations”, the real total equity returns between 1985 and 2014 were 7,9%, i.e. 1,4% to 3 % above the 100-year average. Average bond returns in the US were 5%, i.e. 3,3% above the 100-year average. In Europe bonds yielded 5,9%, means 4,2% above average.

Painful Adjustments

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 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.

With inflation declining sharply since its peak in the late 1970s, the falling investment, higher savings and Central Bank action reduced interest rates, which are now negative in some countries.

Given the probability, that the steep drop in interest rates is unlikely to continue and stalled employment growth could weigh on GDP growth, the future returns will be lower.

In two scenarios for slow growth and growth recovery as outlined in the McKinsey Global Institute (MGI) report, the US and Western European equity and bond returns fail to match those of the past 30 years and could be lower than the 50- and 100-year averages.

Scenario 1

Slow growth could reduce total US equity returns by more than 250 basis points and bond returns by 400 basis points or more below the 1985–2014 period.

Scenario 2

In a growth-recovery scenario, US equity and bond returns would be 140–240 and 300–400 basis points, respectively, below the average of the 1985–2014 period

In both scenarios returns over the next 20 years will be substantially lower.

Now, what would be necessary for equity and fixed-income returns to remain as strong as in the past, and what would we need to change for returns to underperform even the slow-growth scenario?

In the US the real GDP growth would have to be at an average of 2.9% and in the rest of the world GDP would have to be 3.4%, combined i.a. with an increase in margins of one percentage point and a weaker inflation of 1.6%.

Conversely, what would make equity returns drop even lower than projected in Scenario 2 above?

If for US equities margins declined to 7.1%, real equity returns would be 3 to 3.5% over the next two decades with asset-light industries having to decline by about 30%.

In another scenario, global GDP that fell below the slow-growth forecast could bring with it the risk of renewed recession or stagnation, and lower returns.

Other than that, European returns will also likely be lower in the next two decades. Even in a growth-recovery scenario, Western European real bond returns could be close to zero or negative in the first years in some countries.

The Need For Alternative Assets

In a nutshell:

· Household and pension funds are at risk from lower returns.

· Even baby boomers who have been saving for retirement may be caught short in an era of lower returns.

· Public pension funds could experience widening funding gaps and solvency risks.

· Private pension plans also face funding gaps.

· The trend to defined-contribution private pension plans has shifted the risk of lower returns to households.

· Policy makers will face challenging social, political, and economic choices.

· Asset managers may have to review their investment strategies. One option would be for them to include more alternative assets in the portfolios they manage.

A general saying goes: “Past performance is not necessarily indicative of future results“.

In view of all the reasons behind the extraordinary past results in equity and fixed-income markets in the West, investors — both individual and institutional — are well advised to take them into consideration when taking decisions and investments in the future.