THE FUTURE IS NOT WHAT IT USED TO BE
A recent McKinsey Global Institute report1 advocates that the 30 years ended 2014 were a “golden era” for investment returns and suggests that investors should ready themselves for lower real returns (returns after removing inflation) in the next two decades. PAUL CLUER explains the rationale and repercussions for investors.
McKinsey's sobering message is premised on the fact that the conditions that delivered abnormal long-run returns in the last 30 years are now weakening or even reversing. Indeed, a comparison of multi-decade developed market equity returns seems to support this hypothesis (see Figure 1).
In the US and Western Europe, inflation and interest rates have declined steadily over the past decades. Over this time, global gross domestic product (GDP) growth and corporate profit margins were both above their long-term means, largely attributable to major productivity gains as technologies improved. As interest rates have declined, capitalisation rates (see Did You Know?) have fallen and the prices of financial and physical assets have ballooned. Ignoring major market dislocations and financial shocks, the historic price-earnings multiple of the US S&P 500 Index has steadily risen to 25-times trailing reported earnings, also well above its long-term mean. In industry parlance, equity markets are "expensive."
A high-level summary of McKinsey's hypothesis is that interest and inflation rates must rise: Interest rates have persisted at historic lows for almost eight years and are likely to rise with inflation as global economic growth gains traction. As interest rates rise, capitalisation rates will reverse and markets will decline from their current elevated levels. Furthermore, GDP growth as classically measured is likely to be weaker than it has been in the past without further productivity gains and developed market corporate profit margins are likely to be eroded by competition from emerging market companies and new technologies.
For investors, the consequences of lower real returns are twofold. Firstly, longer investment horizons will be required to reach accumulation goals. Secondly, drawdown rates from accumulated retirement savings must be lower if pensioners' capital is to be preserved for longer in this era of increased longevity. In our view, drawdown rates not exceeding 4% per annum are prudent in the current economic environment. Drawdown rates should be reviewed on a regular basis.
The McKinsey report is useful as it corroborates Foord's own conclusions and expectations for lower future returns. Further, in the next seven-year cycle, we believe these returns will be asymmetrically earned: They will be especially low in the next two to three years, improving slowly thereafter. Generating inflation-beating investment returns in this future scenario is not impossible, just more difficult. Foord's track record and the conviction levels of its portfolio managers suggest that the company is up to the task. But for now, Foord's portfolio managers are in capital preservation mode.
1 Diminishing returns: Why investors may need to lower their expectations, McKinsey Global Institute, May 2016