An extraordinary decade for investors has now drawn to a close. Including dividends, the S&P 500 has returned about 13.5 percent a year since 2010 – the fifth best decade for U.S. stocks since 1880. Balanced portfolios have been a beneficiary of this bull market as well, with the composite index (a proxy for a typical 60-40 stock/bond portfolio) returning more than 9 percent over this same time period.
Yet evidence is building that economic growth is likely to slow, driven by several powerful factors that have emerged since the financial crisis. This trend holds significant implications as returns from most major asset classes are unlikely to match those of the last decade. The human mind is naturally wired to extrapolate and recent experiences dominate, but after such a strong decade, these traits are potentially risky. Overly optimistic future return assumptions can lead investors to save less, or more concerning, move too far out on the risk curve.
Three drivers of a “new normal” of lower growth
Firstly, geopolitical instability is playing a significant role in dampening business investment globally. As I speak with business leaders, policy uncertainty and political risk is by far their major source of concern, and ambiguity around everything from Brexit to global trade skirmishes and U.S. foreign policy is driving businesses to invest less – particularly on long-term capital projects. This is a double whammy for investors; not only does it dampen growth and aggregate demand today, it reduces productivity growth in the future. It is hard to imagine a scenario where major developed markets can maintain growth rates in the face of stagnant productivity and declining working age populations.
Secondly, evidence suggests that low interest rates have not been as effective in stimulating growth as in previous cycles. While prior periods of declining interest rates boosted spending and investment, in part because lower rates were viewed as temporary – creating urgency among consumers and businesses to capitalize on the opportunity – today's explicit ‘lower for longer’ guidance tempers this response. Furthermore, for economies with aging populations, low rates reduce income for savers – a growing constituency in any aging population – and offsets some of the boost to spending and investment.
Third, and importantly, I would suggest the world is now in poor shape to respond to the next downturn. When the history books are written on this economic era, they will reflect the fact that the burden of maintaining global economic growth was disproportionately carried by central banks. With geopolitical uncertainty acting as a ‘foot on the brake’ of global growth since the financial crisis, central banks have been forced to step on the accelerator via accommodative monetary policy. With both facets of economic policy out of gas, there will be far less oomph to drive demand and growth in the next slowdown, which may very well be longer and the recovery slower.
High asset prices and low global growth, what’s an investor to do?
Given these unfavorable trends, there is little doubt we have entered a new era of slower growth and low interest rates, implying less fuel for markets and investors to run on over the long-term. Faced with this challenge, investors are left with two options. The sensible path would be to reset expectations away from the last decade’s rates of return. However, the lessons of history suggest a different course of action is more likely – that investors will move out on the risk curve, reaching for returns above what can reasonably be expected, while trying to maintain past glory.
In my view, this is a mistake. While taking assumed rates of return down from this last decade by 30 to 40 percent can feel uncomfortable, maintaining unrealistic assumptions is by far the riskier approach. Every economic up cycle sows the seeds of its own demise and unless we bring expectations back in line with a more muted economic reality, this one will be no exception.