McKinsey Assesses Future Stock and Bond Returns: Are the good times really over for good?
Are stocks’ glory days behind us? What about bonds? As the late Merle Haggard asked in song, “Are the good times really over for good?” A widely circulated McKinsey Global Institute (MGI) report, Diminishing Returns: Why Investors May Need to Lower Their Expectations, suggests that they are. The report makes the case that both stock and bond returns over 1985-2014 were exceptional and that investors should expect lower returns in the future.
McKinsey forecasts a real (inflation-adjusted) stock market total return, including dividends, that ranges from 4% to 5% in their low-growth scenario to 5.5% to 6.5% in their higher-growth scenario; those compare to a historical average of approximately 5.9% (since 1926). Both scenarios acknowledge the currently low growth rate of the U.S. economy – approximately 2% over the last several years, versus a historical average of 3.3% – but the second scenario has the growth rate gradually rising to its historical average.
The McKinsey report also makes forecasts for bonds. Their low-growth forecast is for a real return on 10-year U.S. Treasury bonds of zero to 1%, and their higher-growth forecast is for a real return of 1% to 2%. These numbers contrast sharply with recent bond returns, which have been high as interest rates have fallen.
MGI is correct, at least directionally, in their forecasts and for many of the right reasons. But its report fails to adequately address a few critical areas that should be of concern to advisors, as I will outline.
My biggest concern is that the report gives relatively high forecasts for equity returns but calls them low forecasts, as if the authors are sure investors are expecting even more. This is a subtle but important point; if the good news is that the bad news is wrong, someone ought to say so. After all, the report could have been titled “Oh No! Stocks Projected to Deliver Large Profits, but Less than During the Best Years in its History.” Other shortcomings include confusion as to when the best historical returns occurred and a failure to recognize that many investors rely on forecast methods that are better than merely projecting past returns into the future.
The equity returns projected by MGI are quite attractive. At real 4%, you double your purchasing power every 18 years. At real 6.5%, every 11 years. What more do you want? The great bull market of 1981-1999 may have accustomed investors to capital market conditions that were almost miraculous, but most investors understand that such an event is not repeatable. Someday in the far future we will have bull markets of comparable magnitude, but not soon and not starting from the valuation levels that currently prevail.
The main points of the rest of this article are:
- The really high returns in the equity market were earned over 1985-1999, not 1985-2014; the 2000-2014 period was far below average and below what MGI is forecasting, so they’re actually forecasting an increase in returns relative to the last 15 years. (My analysis goes through 2014 because that is what MGI’s did, even though 2015 data are now available.)
- As Eugene Fama and Kenneth French demonstrate, investors didn’t expect the high returns they got.
- The discount rates used by pension funds, cited by MGI as indicative of investor expectations for asset-class returns, are manipulated and are not an accurate guide to what investors really expect.
- Future returns on bonds will be much worse than they were historically; the report gets this right.
Finally, the MGI report introduces a decomposition model of stock returns. This analysis is of high quality and I reproduced MGI’s diagram of the model here for one asset class for one period (equities, 1985-2014) so you can see how MGI thinks about the return-generating process.
The glory days were 1982-1999, not 1985-2014
First, let’s look at the data. Here are compound annual real returns over various periods:
Compound annual real returns on principal U.S. asset classes
The stock market is what most people care about when they think of markets being good or bad. So it’s clear from Exhibit 1 that the glory days of the stock market ended in 1999; returns over 2000-2014 have been well below expectations (both investors’ own expectations for that period and MGI’s expectations for the future). It’s fatuous for MGI to talk about the last 30 years as if that were a single economic environment. And both they and I expect equity returns to rise, not fall, relative to the miserly standard set by the 2000-2014 period.
Bonds are a different matter. The bond bull market continued into the 21st century, and future bond returns will be lower because the starting yields are as low as you can get. Despite the Alice-in-Wonderland existence of negative interest rates in Europe and Japan, I do not expect them here, and that’s what it would take to produce significant further capital gains in the bond market. So the future for bond investors looks disappointing.