Investors in both bonds AND equities have had a terrific last few years. As interest rates have hit close to zero, the price of most risk-based financial assets (bonds and equities) has shot up, with correlations tightening across the board. Now that US interest rates are rising again, investors might reasonably expect the price of some risk assets (bonds and maybe even equities?) to fall and correlations to increase. But what do these trends tell us about potential future returns?
Crystal ball gazing is always a fraught exercise in investment but some brave investors do try to build a model of future returns using past measures – and valuations – as a guide. One such firm is called GMO, led by veteran British investor Jeremy Grantham, with $71 billion in AuM. GMO tends to subscribe to a slightly more value-driven, more cautious approach to investment and it’s just released its own projections for future returns from a wide range of asset classes. It’s bottom line? “Not one asset class is expected to provide even a 2% return over 7-years, says GMO. Nothing is cheap, so investors are asking “Are we in Purgatory or Hell?” when contemplating whether valuations will revert back to the mean quickly or slowly.”
The table below details GMOs predictions for 7-Year Asset Class Real Returns.
US large caps are expected to produce negative real annual returns of 4.2% while International equities might return -0.4% per annum. By contrast, emerging markets equities are forecast to return 1.9% in real terms, with EM bonds not far behind. Over in bondsland, US bonds will produce negative real returns of 0.2% with international bonds lagging a long way behind with a return of -2%. US cash, by contrast, will produce a net real return of 0.8% pa. The key point though is that all these investment classes will produce negligible returns (or losses) when compared to the long-term historical return of 6.5% for equities – widely used as a benchmark for US pension fund returns.
The investment implications? A variant on the barbell approach – invest in cash and emerging markets equities & debt. As strategies go, this doesn’t sound like a completely bonkers one.
Obviously, this GMO forecast is based on the firm’s own internal valuation metrics – and not every investor will necessarily buy into their pessimistic worldview and analysis. Nevertheless, it’s hard to argue with the common-sense observation that equity markets must be closer to ‘expensive’ than ‘cheap’, with the long-term law of averages suggesting that the days of easy returns must be drawing to a close.