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Two recent research papers triggered the question of whether it is possible for equities and
real estate to structurally produce returns higher than underlying economic growth.
• US pension funds assume extremely high future returns
• Past returns boosted by high dividends, rising earnings
• Neither seem to be repeatable in the decades to come
Although this is indeed feasible, future returns may not be as generous as they have been in
the past, says Daalder, Chief Investment Officer of Robeco Investment Solutions.
The first research paper, entitled ‘The Return Expectations of Institutional Investors’, looked
at the long-term expectations of 230 US pension funds. According to the study, their
nominal average expected return is 7.6%, resulting in an expected real return of 4.8%. This
is based on long-run average nominal returns on cash (3.2%), bonds (4.9%), real estate
(7.7%), hedge funds (6.9%), publicly traded stocks (8.7%) and private equity funds (10.3%).
Somewhat ambitious
“This looks pretty ambitious given that historically, OECD data shows that the average annual
realized return that these US pension providers over 2006-2016 was 1.5% in nominal terms
and -0.3% in real terms,” Daalder says. “And that was despite the average total return of
the S&P 500 coming in at 6.9% during this timeframe.”
“Given the continued decline in productivity seen in recent decades, as well as the popularity
of the secular stagnation school of thought, it raises the question of how realistic the return
expectations for the riskier parts of their portfolio really are,” says Daalder.
“By way of comparison, Robeco’s own long-term (steady state) expected nominal return on
equities is 7%, while bonds are expected to yield 4.25%. As such, you still need a pretty
optimistic view of the world to get to a 7.6% longer-term return envisaged by these pension
funds. Even when ignoring the early February stock market correction, recent performance
clearly does not support these kinds of return expectations.”
Link with economic growth
Daalder says it begs the question of whether there is a direct link between economic growth
and asset returns that would make forecasting more reliable. He says the answer to that
question partly comes from the second piece of research, entitled ‘The rate of return on
everything, 1870-2015’. In this study, the authors look at the historical track record of the
nominal and real returns of 16 developed nations since 1870.
“The picture in this study is clear: with the exception of the two decades that marked the
world wars, returns have been quite clearly in excess of the underlying real growth rates of
the 16 countries studied,” Daalder says. “The average real growth rate over the period was
3.1%, while the diversified portfolio return was 5.9%. But there is a catch.”
“Looking at the breakdown of the portfolio used, it is clear that all of this so-called ‘excess’
return came from the risky assets: the returns on cash (1.3%) and bonds (2.5%) on average
lagged the growth of the real economy, while the returns on stocks (7.0%) and real estate
(6.7%) exceeded it.”
“Based on these historic returns, the 4.8% assumed real return of pension funds all of a
sudden does not appear to be too outlandish after all. However, this outcome raises a
number of questions, led by asking how is it possible that returns on risky assets can
structurally outstrip growth.”
Role of dividends
Part of the answer lies in the role that dividends have played in generating the ‘excess’ return
made in equities and real estate in the past, Daalder says. According to the Shiller database,
the total geometrical nominal return for the US has been 8.9% since 1871, while the average
annual dividend yield over that timeframe has been 4.4%.
“As such, this seems to be a valid and stable reason to expect returns in excess of growth,
which can be seen as compensation for the risks involved with equities compared to risk-free
assets such as bonds and cash,” he says.
“The story doesn’t end there, however. Stock prices have also risen more than the underlying
growth rate of the economy, adding to the excess return recorded in the past. This is partly
because there is a structural mismatch between the earnings growth of listed companies –
which only represent a small subset of the economy – and wider economic growth.”
“Meanwhile, higher levels of leverage, and exposure to growth outside the 16 reported
countries (the emerging markets), are all factors that can lead to higher earnings growth
compared to GDP growth.”
Too much wealth will lead to lower future returns
Daalder says another problem with future expected returns is that rising PE levels over many
decades mean that stocks have structurally become more expensive over time.
“You only need to look at the very low yields that we currently see in the bond market to
make the point: these low future returns have come on the back of above-average returns
as bond prices were bid up. You see the same process in real estate and equities: you get
above-average returns on your investment as stocks and houses are being bid up, but this
leads to a reduction in future dividend yield or rental returns.”
“Which brings us back to dividends being an important part of the excess return we have
seen in the past. The long-term dividend yield has been 4.4% for the US, but if we look at the
current dividend yield of the S&P 500, this has declined below the 2% level. Given the
importance of dividends in the ‘excess’ return, it is pretty safe to say that from this starting
level, one should not expect the same returns that have been reached in the past.”
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