After nearly 10 years of record-breaking advances in stock prices, investors are being advised to brace for sharply lower investment returns over the next decade. Looking at 17 major asset classes, Morgan Stanley finds that 14 of them have registered negative, inflation-adjusted real returns so far this year, the worst scorecard since 2008, the year of the financial crisis.
As reported by Bloomberg, these findings are summarized in the table below.
Worst Real Returns Since Financial Crisis: A Look at 17 Asset Classes
|S&P 500 Index (SPX)||2-Year U.S. Treasury Note|
|Russell 2000 Index (RUT)||10-Year U.S. Treasury Note|
|U.S. high yield corporate debt||U.S. investment grade corporate debt|
|Global high yield corporate debt|
|U.S. Aggregate Bond Index|
|Emerging market U.S. dollar government debt|
|Emerging market local debt|
|MSCI Europe Index|
|MSCI Japan Index|
|MSCI China Index|
|MSCI Emerging Markets Index|
Sources: Morgan Stanley, Bloomberg; Annualized, unhedged inflation-adjusted real returns in U.S. dollar terms computed YTD as of Sept. 24.
How It Matters For Investors
"There always seems to be a level of griping, on both the buy- and sell-side, that conditions are challenging for one reason or another," a team of Morgan Stanley strategists, led by Andrew Sheets, observed in their report, as quoted by Bloomberg. They added, "but this year it really seems to be the case."
While investors who are solely in U.S. stocks generally have done fine so far this year, the reality is that many more investors hold diversified portfolios containing other asset classes. So far this year, such diversification aimed at reducing risk has been a losing strategy. Meanwhile, U.S. high yield corporate debt, which often is viewed as an equity proxy, is among the few winners so far in 2018. However, it is barely in positive territory, with a mere 0.2% real annualized return. Moreover, all these asset classes are among the most expensive, making it highly likely that they are due for downturns in valuation.
Rising real interest rates, as the result of tightening by the Federal Reserve, are set to reduce these valuations. Morgan Stanley writes, per Bloomberg: "Rising real rates here are not an automatic negative, but do reflect that an age-old pattern is unfolding: Better growth --> Fed tightening --> higher real rates --> slower growth --> equities, challenged by a higher discount rate and the growth drag." That is, as interest rates rise, the rate at which anticipated future corporate profits are discounted also rises, producing a lower present value of those earnings, and thus lower stock valuations.
Stock Returns Also May Plunge
|Time Period||S&P 500 Average Annual Total Return|
|Since Sept. 1871||9.1%|
|Since March 2009||17.3%|
Sources: DQYDJ.com, Barron's.
As detailed in the table above, Nobel Laureate economist Robert Shiller of Yale University, developer of the CAPE stock market valuation methodology, expects sharply lower U.S. stock returns in the near future. He did not put an exact time frame on his forecast, but he notes that such a large decline in returns is necessary to reduce the stretched equity valuations of today, bringing them closer to historic norms. Shiller's data set consists of monthly stock price, dividends, and earnings data and the consumer price index (to allow conversion to real values), all starting January 1871. (See also: The Stock Market Is About to Turn Ugly for Investors: Shiller.)
What the Future Holds
The Fed's plan to increase interest rates, partly through a reversal of quantitative easing (QE) in which they reduce their massive bond portfolio, promises to reduce the valuations of key asset classes. Meanwhile, rising inflation will cut into the real rates of return on many of those asset classes. Investors may need a complete rethinking of their investment strategies to cope with this less hospitable investment environment.
Bank of America Merrill Lynch also anticipates sharply lower returns on stocks going forward. Their recent report includes detailed recommendations for investors. (See also: The Raging Bull Market Is Over: So, What's Next?)