Are We in a Lower Return Environment?

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In recent meetings with clients, we have often presented a graphic that shows the average annual returns of the U.S. stock and bond markets from 1986 to today. Why that particular 30-year time period? Because it almost exactly corresponds to my career in the investment business. It also, coincidentally, parallels a historic bull market in bonds (average annual return of almost 7%) and a very respectable, though historically average, stock market as well (U.S. stocks have average 10-12%/year over the last 90 years).

But, that is the past. A much more important question to today’s investors is, what does the future hold? And while we certainly don’t claim to know exactly where the markets will end up in 2016, we and many other successful investors see headwinds to those types of historic returns, at least over the relative short-to-intermediate term. Bill Gross, commonly known as “the Bond King,” is one of the worlds most successful investors over the last three decades, and someone we have followed, respected, and consistently entrusted with client assets. In his April investment outlook, he puts it better than I could ever express, as he describes the hopeful math of our low interest rate environment for investors:

I once wrote that a good “bond manager” should metaphorically be composed of 1/3 mathematician, 1/3 economist and 1/3 horse trader. I still stand by that, although I would extend it now to the entire investment arena, especially after experiencing several years of “unconstrained” asset management. Surprisingly though, upon reflection, I find that personally I was never really an “A+ student” at any of the 3, but good enough at each to provide consistent long term alpha and above average profits for clients. In math, for instance, I was a 720 SAT guy but certainly nowhere near 800 status… [however,] it’s there that I find the average lay and even many professional investors still thinking and managing assets at the grade school level… “Forget about the math,” many investors really seem to say – “let’s stick to the old Will Rogers adage, ‘If a stock is going to go up – buy it. If it ain’t going up – don’t buy it’!” Well today’s markets are markets that increasingly will be dominated by math, not Will Rogers. And negative interest rates are front and center.

Mr. Gross goes on to explain that the actions of central banks around the world (the ECB, Bank of Japan, Bank of England, the Federal Reserve, etc.) in creating low to negative short-term interest rates as an attempt to boost economic growth appears to be an exercise in economic and mathematical theory only, but the reality of these forces is a dampening of current return expectations, for both equities and fixed income, unless economic growth is indeed stimulated (something that hasn’t happened yet, though we are already 7 years into these experiments.)

He explains:

Negative interest rates are real but investors seem to think that they have a Zeno like quality that will allow them to make money. In Germany for instance, 5 year Bunds or OBL’s as they are called, yield a negative 30 basis points. That produces a current price of 101.50 at a 0% coupon that guarantees, guarantees that an investor will get back 100 Euros 5 years from now for every 101.50 Euros she invests today. Why would a private investor (the ECB has a different logic) buy a 5 year OBL at a minus 30 basis points and lock in a guaranteed loss? Well credit and electronic money has its modern day disadvantages in that you can’t withdraw billions of physical Euro Notes from the local bank, nor can banks withdraw some from the central bank. You have to buy something and that’s the yield that’s artificially being imposed. Besides, the purpose of it is to force the investor to buy something with a positive yield further out the maturity spectrum or better yet with a little or a lot of credit risk to get inflation and the economy’s growth engine started again. Seemingly logical, but as I’ve pointed out in recent years – not working very well because zero and negative interest rates break down capitalistic business models related to banking, insurance, pension funds, and ultimately small savers.  They can’t earn anything! 

But why does it matter what German, Japanese or US treasuries yield? Because we are all linked together as a global investing community, and more importantly, all financial instruments are affected, directly or indirectly, by the machinations of the dominant central banks. Ultimately, investments are priced based on the short term interest rates.

To be clear, we are not predicting doom and gloom, recession, or depression. But as we have already seen over the last 12-18 months, returns on investments may be lower going forward than what I’ve seen over the last 30 years of my career.

You can read Bill Gross’ entire Investment Outlook here.