(Please note the the updated, 2014 edition of this market forecast can be read here.)
Each year, Portfolio Solutions, LLC puts forth a 30-year forecast for stock and bond market returns. This forecast is intended for making long-term asset allocation decisions as opposed to short-term tactical decision. We know it’s not possible to predict short-term asset class returns and do not try. However, it is possible and important to estimate long-term expected returns in portfolio construction.
Our 2013 expected return forecast for asset classes relies on five primary drivers: 1) market risk as measured by comparative price volatility relative to other asset classes; 2) the Federal Reserve’s long-term target for U.S. GDP growth; 3) market implied inflation based on Federal Reserve targets and the difference in yield between long-term Treasury Bonds and long-term Treasury inflation protected securities (TIPS); 4) current cash payouts from bond interest and stock dividends; and 5) a subjective reading of fiscal policy, monetary policy, trade policy, and global competitiveness.
One problem assessing the returns of free markets is that they are never truly free. Artificial forces are at play from government policy (taxes and spending) and monetary policy (inflation and interest rates) that distort return expectations based solely on past data. For example, for decades the U.S. economy has benefited from low-interest rates and outsized borrowing and spending by the federal government.
Experienced investors know there is no free lunch. Borrowing in the past to fund faster growth, without paying it back, must eventually lead to slower growth in the future. In 2009, PIMCO’s Bill Gross coined the era as the new normal. While not all of Gross’s predictions may prove correct, his idea of a new “lower” normal growth rate in U.S. economic activity appears to be right on the mark.
Any credible assessment of future risks and returns has to take into consideration the unprecedented size of the U.S. fiscal deficit and the tripling of the Federal Reserve’s balance sheet. The extra $16 trillion dollars borrowed and spent by the federal government over the last three decades has certainly aided economic growth in the US. The interest payments on government debt have been kept low in recent years by Federal Reserve policy, which has tripled the size of the Fed’s balance sheet.
This process has been accelerating in recent years. Ballooning annual federal deficits have created artificial GDP growth which is being fueled by artificially low interest rates created by Fed policy. Something will eventually give, the question is when.
We believe the words debt crisis will remain front and center in the media for as long as we all live. So, let’s look through the media sensationalism and get to the bottom line.
The U.S. dollar is still the world’s reserve currency and the U.S. economy is still the most diverse in the world. We also own printing presses and will print our way out of a default, if need be. So, economic disaster is several decades away, and there’s always hope that Washington will work together to do what’s in the county’s best interest before a Greek-style collapse.
That being said, we see the expected risk in Treasury securities and investment-grade bonds as low. We don’t believe Treasury rates will jump anytime soon (read Fears of Soaring Rates are Overblown for our view of why this is so). The expected credit risk premium over inflation from investment-grade securities is also expected to remain stable. Our 30 year forecast return forecast for bonds reflects these views.
Long-term inflation expectation is 2.0 percent, which is 0.5 percent less than 2012. The Federal Reserve’s long-term inflation expectation over 10 years is 1.5 percent. The market is pegging 30-year inflation at a slightly higher 2.0 percent rate, which is the spread between long-term 30-year Treasury nominal bonds and 30-year TIPS. Federal Reserve policy to increase the money supply has not led to inflation during this recovery because the demand for money has been lower than in other recoveries when inflation did occur.
The U.S. equity market had a solid year in 2012. Returns were up about 15 percent, not including dividends. According to S&P Dow Jones Indices, corporate earnings are expected to increase by only 3.0 percent in 2012, which was about as fast as the economy grew. Thus, prices exceeded corporate earnings growth by a considerable margin and expanded stock valuation as measured by the price-to-earnings ratio (PE) from 14.5 PE to 16.2 PE. This is about the average PE for stocks historically.
U.S. stocks appear to be fairly valued based at current levels. Accordingly, our 30-year forecast for equity has been adjusted downward by 0.1 percent (we had increased it last year over 2011 because of low valuations).
Stock prices continue to be attractive in the long-term as economic growth continues. Real corporate earnings growth is a function of real economic growth. The most recent economic projections from the Federal Reserve show long-term inflation-adjusted economic growth between 2.3 and 2.5 percent.
International equities were an interesting mix in 2012. European stocks also had a good year and outpaced U.S. stocks, while Asian stocks lagged slightly. Emerging market stocks had a more difficult year − although a positive one. All markets had share price growth that outpaced earnings growth, thus we have lowered our long-term outlook for international markets by the same 0.1 percent as the U.S. market.
The Portfolio Solutions 30-Year Market Forecast is provided for informational purposes only and not intended to be used for short-term market timing. Our intent is to offer a perspective that may assist with long-term asset allocation decisions and investment planning.
This forecast always attempts to err on the conservative side. It is wise to expect and plan for lower returns and then be pleasantly surprised if the forecast is too low. That beats relying on a rosy forecast and running out of money later in life. It is better to be safe than sorry.
Thirty-Year Estimates of Bonds, Stocks and REITs Assuming a 2.0% Inflation Rate
|Asset Classes||Expected Return Prior to Inflation||With 2.0% Inflation||Risk* Estimate|
Government-Backed Fixed Income
|U.S. Treasury bills (1-month maturity)||0.1||2.1||2|
|10-year U.S. Treasury notes||1.0||3.0||7|
|20-year U.S. Treasury bonds||1.7||3.7||8|
|30-year inflation protected Treasury (TIPS)||1.9||3.9||9|
|10-year tax-free municipal (A rated)||1.0||3.0||7|
Corporate and Emerging Market Fixed Income
|10-year investment-grade corporate (AAA-BBB)||1.7||3.7||9|
|20-year investment-grade corporate (AAA-BBB)||2.5||4.5||10|
|10-year high-yield corporate (BB-B)||3.8||5.8||15|
|Foreign government bonds (unhedged)||1.5||3.5||9|
U.S. Common Equity and REITs
|U.S. large-cap stocks||5.4||7.4||19|
|U.S. small-cap stocks||6.4||8.4||22|
|U.S. small-value stocks||7.4||9.4||26|
|REITs (real estate investment trusts)||5.0||7.0||19|
International Equity (unhedged)
|Developed countries small company||6.4||8.4||22|
|Developed countries small value companies||7.4||9.4||26|
|All emerging markets including frontier countries||8.4||10.4||29|
*The estimate of risk is the estimated standard deviation of annual returns, according to Morningstar.Read Blog Disclosure Here