Dismal Future Financial Asset Returns:

Commentary by J.P. Morgan Asset Management

Revised on Dec. 5, 2016 as follows: In addition to the reference to John Hussman (see below at the very end), I added references to Robert Shiller and Fama & French.

On page 12 of the Nov. 28, 2016 issue of the magazine Pensions & Investments was printed an article authored by John Bilton, the London-based managing director and global head of multi-asset strategy at J. P. Morgan Asset Management. The article caught my attenion.

The article's title was "Asset owners face daunting path from continuing central bank challenges." Below are some salient excerpts. Emphasis mine.

"The extremely accommodative central bank policy of recent years may well have prevented economic Armageddon, but it also drove asset returns far in excess of underlying economic growth. In the past 50 years, U.S. stocks have, on average, outrun gross domestic product growth threefold during phases of economic expansion. In this post-financial crisis expansion, U.S. stock markets have outstripped the U.S. economy by almost eight times. Absenting a remarkable sustained and successful period of fiscal stimulus, an inescapable conclusion is that this extended period of policy largesse -- designed to stabilize the economy -- resulted in asset returns being borrowed from the future, and now that future is here."

Some comments for readers who may be less familiar with facets of what's being said: 

• The "accommodative central bank policy" and "period of policy largesse" both refer to policies of quantitative easing since the Great Financial Crisis of 2008/2009.
• The author is making the valid comparison between stock market growth rates and growth rates in the real economy. Think of it in these steps: (1) The real economy grows. (2) Company earnings grow. (3) Stock prices rise. Withouth (1), (3) is not based on fundamentals but on what we can call investor sentiment or risk tolerance.
• The author's mention of "fiscal stimulus" is reference to president-elect Donald Trump's intention to spend $1 trillion on infrastructure projects over a 10-year period. (The media has reported on this at the following sources: Washington Post, CNN, CNN Money, Politico, FiscalTimes, BusinessInsider)
• The author wants readers to understand that equity markets cannot go up forever and that if they have already gone up too much, they are likely to either not go up for a while or worse, drop.
• Personally, I found the contrast between a "threefold" increase from history and the "almost eight times" increase in the current cycle jaw-dropping.

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On to the next excerpt. Emphasis mine.

"We find ourselves caught in an uncomfortable, but potentially enduring equilibrium: growth is unlikely to be strong enough to support a sharp rise in interest rates, yet at the same time the exuberance and excess that often mark the end stage of an economic cycle are palpably absent. Some may call this a "Goldilocks" scenario; but if it is, then it's a rather bleak read of the fairytale [sic]. Poor demographics and weak productivity combine to peg the long-term outlook for developed market real growth at just 1.5% over the next decade. This translates to a significantly slower and shallower path of global interest rate increases, and lower terminal rates for both the cash rate and 10-year yields. In turn, any hope asset owners have for higher yields or better growth is likely to be a long time coming."

My comments:

• If the current situation is indeed an equilibrium, meaning that if we believe that it will persist, it characterizes quite a strange world because of the following. (A) Economic growth is anemic and as a result, interest rates won't be able to go up, but still, the Fed intends to raise them. (B) Despite the fact that we are most likely at the end of a business cycle, sentiment among people and investors is not one of exuberance and excess.
• The fact of the matter is that we face a future characterized by "poor demographics" and "weak economic productivity", neither of which signals strong economic growth. Therefore, we should expect a slow path of interest rate increases across the globe.
• The bottom line is that bond investors hoping for "higher yields" (in order to buy bonds) should restrain their hope. So should equity investors hoping for higher stock prices based on "better growth".

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On to the next excerpt. Emphasis mine.

"A future in which returns are expected to be muted means that reaching the hurdle rate to meet long-term objectives -- like the increasingly elusive but still psychologically powerful 8% annual return target historically considered achievable for a balanced, moderate risk portfolio -- is going to require a lot more creative thinking and much more active diversification."

My comments:

• It is a mathematical fact that at 8% annual growth, capital doubles every 9 years. In contrast, at a 1.5% annual growth rate, capital doubles every 47 years! (Assuming annual compounding) There is a generation of difference between 9 years and 47 years.
• The future does not look good for investors. This includes pension funds and insurance companies! It should also be a wake-up call for retirees and those approaching retirement age.

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On to the next excerpt. Emphasis mine.

"Based on a multidecade [sic] set of assumptions that underscores the economic and capital market estimates we have been compiling for the past 21 years, on a 10- to 15-year outlook, ... real assets are likely to hold up best in a world of challenged growth and lackluster returns."

My comments:

• The author's observations about "real assets" is based on historical data. It is not an opinion. (However, one could argue that 21 years is too short of a look-back period, and especially given the strange nature of the "current equilibirum," that we ought to be looking back all the way to the 1929 Great Depression and even further back ... This is easier said that done because it is certainly not be easy to obtain the data. Some have tried, successfully. E.g. (1) quantitative equity manager John Hussman, (2) Robert Shiller, (3) Fama & French.)
• "Real assets" consist of the following, which is not necessarily exhaustive list: real estate, infrastructure (toll roads and bridges, oil & gas pipelines), timberland, farmland, precious metals, fine art, and collectibles.

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