The next 15 years Is there a New Normal ahead? Delaware Investments Presentation Richard C Marston Wharton School, University of Pennsylvania
Outline 1. Is there a New Normal ahead for stocks? 2. Is the thirty-year bull market in bonds finally over? 3. Is it possible to avoid the New Normal by diversifying beyond U.S. stocks and bonds? Diversifying into fast growing economies Diversifying into alternative investments
Bill Gross introduced the New Normal too soon in May 2009 S&P 500 reached its bottom on March 9, 2009 just six months after Lehman failed. It has been a great cyclical rally ever since then. Through September 2016, the S&P 500 is up by 220% After a recession, we always experience a sharp cyclical rally
S&P 500 Index S&P 500 in Last 15 Years, 1999-2016 Source: S&P 2200 1800 1400 1000 600 2000 2004 2009 2014
Dates of Recession Returns after Recession: S&P 500 return in 1 st 12 months Source: Investing for a Lifetime (2014), Table 3.3 Dec 07-Jun 09 49.8% Mar 01-Nov 01 Jul 90-Mar 91 33.5% 38.5% Jul 81-Nov 82 59.3% Nov 73-Mar 75 Dec 69-Nov 70 Apr 60-Feb 61 Aug 57-Apr 58 Jul 53-May 54 37.3% 41.9% 32.6% 43.4% 46.0% 0% 10% 20% 30% 40% 50% 60% 70%
The true New Normal Yet Bill Gross may be right that stock returns in the future will not what they have been in the past. Future stock returns may not be as high as in the past because growth in the industrial world has slowed down.
Real GDP Growth in Japan Source: IMF, international Financial Statistics 6% The collapse in growth occurred in Japan 25 years ago 4.6% 4.7% 4% BRICs 2% 1.0% 0.7% 0% 1971-1980 1981-1990 1991-2000 2001-2015
Growth per Annum Real GDP Growth in Europe Source: IMF, International Financial Statistics 4% France Germany 3.2% 3% 2% 2.7% 2.5% 2.3% 2.1% 2.9% 1% 1.0% 1.1% 0% 1971-1980 1981-1990 1991-2000 2001-2015
Growth per Annum 4% Real GDP Growth in United States Source: Bureau of Economic Analysis 3.2% 3.4% 3.4% 3% 2% 1.8% 1% 0% 1971-1980 1981-1990 1991-2000 2001-2015
Long view of U.S. growth U.S. economy grew rapidly in the 19 th century but never as fast as China! Slowdown in 1930s depression, then postwar boom that extended until 2000.
Percent per annum U.S. GDP growth since 1870 Source: NIPA, Table 1.1.6 and F 10-16 5% 4.2% 4% Postwar boom 3% 3.1% 3.2% 3.2% 2% 1.7% 1.8% 1% 0% 1870-1913 1913-1929 1930-1940 1946-1972 1972-2000 2001-2015
Long view of U.S. growth Growth in industrial countries is slowing partly because productivity growth is slowing. A major reason for the slowdown in the growth in output per hour is the shift of the economy towards services and away from manufacturing. Productivity in most service sectors is way below that in manufacturing or agriculture or mining
Annual Growth in Productivity in Services, 1987-2014 Source: Brookings Institution (WSJ, 10-31-16) Accomodation/Hospitality Administrative Services Computer Systems/Services Food Services Social Assistance Eduational Services Hospitals/Residential Care Legal Services -1.0% -0.5% 0.0% 0.5% 1.0% 1.5%
Two Trends in Manufacturing Will examine two trends in manufacturing since 1980: 1. Growth in manufacturing output (adjusted for inflation) 2. Growth in employment in manufacturing
Index (1980 = 100) Production and Employment in Manufacturing 300 250 Manufacturing Output 200 150 18.6 million jobs 100 12.3 million jobs Manufacturing Jobs 50 1980. 1985. 1990. 1995. 2000. 2005. 2010. 2015 Bureau of Labor Statistics and Council of Economic Advisors
The true New Normal Another reason growth is slowing is that the industrial countries are aging. That s particularly true of Japan, Germany and Italy. Look at share of population that is 65 years or older.
Share of Population 65 Years or Older Source: Pew Research Center using United Nations data Japan Germany Italy France 2050 2010 U.K. U.S. 0% 10% 20% 30% 40%
Stock returns in developed markets Stock returns in the developed (or industrial) countries over the last 45 years or the last 30 years have been quite impressive. But the last 15 years have been a different story. Let s divide developed markets into three sets of markets: 1. U.S. market represented by the S&P 500 index 2. European portion of the MSCI EAFE index 3. Pacific portion of the EAFE index (Japan, Australasia, Hong Kong, and Singapore)
Return per annum Stocks in developed markets Sources: S&P and MSCI 14% 12% 10% S&P 500 EAFE Europe Pacific Last 30 years 11.4% 11.5% 10.3% 10.0% 9.5% 9.2% 9.4% 8% 6% 4% 2% 6.9% Last Last 15 15 years years 4.3% 3.4% 2.9% 1.9% 0% 1970-2015 1986-2015 2001-2015
Stock returns in real terms Investors in the long run are interested in real (or inflation-adjusted) returns. Let s look at the same returns adjusted by the U.S. inflation rate (since the returns are measured in dollars). This chart shows how miserable stock returns have been over the last 15 years.
Return per annum Stocks in developed markets: real returns Sources: S&P and MSCI 10% S&P 500 EAFE Europe Pacific 8% 8.4% 8.5% 6% 4% 5.9% 5.7% 5.2% 4.9% 6.5% 4.0% Last Last 15 15 years years 2% 2.0% 1.1% 0.6% 0% 1970-2015 1986-2015 2001-2015-0.4% -2%
2) A New Normal for bonds? Bill Gross talked about a New Normal for stocks. But what about bonds? Surely, there is a New Normal ahead for bonds. The bull market for bonds has lasted for 30 years.
Per Annum Figure 3-3 U.S. Inflation and Bond Yields, 1954-2015 Data Source: IMF, International Financial Statistics and Bureau of Labor Statistics CPI Inflation 10 yr Treas Yield 16% 14% 12% 10% 8% 6% 4% 2% 0% 1954 1964 1974 1984 1994 2004 2014-2%
Factors influencing interest rates A. Fiscal deficits B. Monetary overhang Fiscal deficits have been reduced dramatically in last few years.
Percent of GDP Federal Expenditure as Percent of GDP, 1960-2015 Economic Report of the President (Feb 2016) 26% 24% 20.7% down from high of 24.4% of GDP 22% 20% 18% 16% 1960 1970 1980 1990 2000 2010
Percent of GDP U.S. Tax Receipts as Percent of GDP, 1960-2015 Economic Report of the President (Feb 2016) 22% 20% 18.3% up from low of 14.6% of GDP 18% 16% 14% 1960 1970 1980 1990 2000 2010
Percent of GDP U.S. Fiscal Deficit as Percent of GDP, 1960-2015 Economic Report of the President (Feb 2016) 4% 2% 0% -2% -4% -6% -8% -10% -2.5% up from low of -9.8% of GDP -12% 1960 1970 1980 1990 2000 2010
Factors influencing interest rates The election results promise that this favorable trend will not continue. Infrastructure spending Large tax cuts
B. Monetary overhang Federal reserve did heroic work during the financial system providing massive liquidity to save banking system and bolster economy. But legacies: 1. Fed balance sheet has ballooned. 2. So has cash at commercial banks.
$ Billions Assets on Fed s Balance Sheet Source: Federal Reserve Board $5,000 $4,000 Start of QE3 Start of QE2 $3,000 $2,000 Start of QE1 QE1 QE2 QE3 Other Assets Loans Other Securities U.S. Treasuries $1,000 Federal Reserve H.4.1 Release $0 1/5/2005 1/5/2008 1/5/2011 1/5/2014
$ Billions $3,000 Cash assets at commercial banks $2,000 Start of QE3 Start of QE3 Start of QE2 Start of QE2 $1,000 Start of QE1 Start of QE1 $- Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Source: FRB H8 Series
Now what? A New Normal for bonds Does anyone at the Fed know how to get back to normal? Two scenarios for bonds: 1. Good scenario: Interest rates stay low forever. (In that case, real yields stay close to zero). 2. Bad scenario: interest rates rise. That surely is a New Normal for bonds
3. Is it possible to escape the New Normal by diversifying? If U.S. stock and bond markets promise lower returns, will diversification help? 1. One possibility is to diversify into countries that are growing much faster than the United States the emerging markets. 2. Another possibility is to diversify into alternative investments. Let s explore each possibility.
A. Diversifying into emerging markets Since 2001, emerging markets have earned the highest stock returns, easily beating the U.S. and other developed stock markets. Maybe emerging markets will help investors to escape the New Normal. In November 2001, Jim O Neill of Goldman Sachs introduced the BRICs Heralded an impressive decade of high stock returns not only in the BRICs, but emerging markets as a whole.
Figure 9-6 Returns in the BRIC Countries and Emerging Markets as a Whole Data Source: MSCI Return/Annum 20% 1995-2001 2002-2015 14.1% 14.1% 12.6% 10% 8.2% 6.7% 9.7% 0% 1.2% -5.0% -4.1% -10% -20% -16.8% Brazil Russia India China MSCI EM
Decade of the BRICs But then in December 2013, Goldman Sachs published Emerging Markets: As the Tide Goes Out which forecast a prolonged slowdown in stock returns in the emerging markets. Is it wise to look for salvation there?
Emerging markets have faltered over last 5 years Stock Returns in Emerging Markets Source: MSCI EM Index Return per Annum 18% 14% 16.2% 10% 6% 8.3% 2% -2% -6% -4.5% -10% 1991-2000 2001-2010 2011-2015
China has led all emerging markets in growth China has grown rapidly for over three and ½ decades.
Growth Per Annum Real GDP Growth in China, 1979-2013 Source: IMF, international Financial Statistics 12% 10% 9.9% 9.0% 10.4% 10.0% 9.7% 8% 6% BRICs 4% 2% 0% 1979-85 1986-92 1993-99 2000-06 2007-13
Employment in Sector (% of GDP) Key: lots of labor available Share of Employment by Sector in China Source: China Statistical Yearbook, 2013 90% 60% 30% Agriculture Industry Services 0% 1952 1982 1992 2002 2012
But now wages are rising rapidly Wage Increases in China Source: China Statistical Yearbook, 2013 80,000 60,000 Average wage increase = 13.6% per annum 40,000 Total Wage Bill Average Wage 20,000 0 1995 2000 2005 2010
Will China slow down? China also confronts an aging problem almost as bad as in Japan, Germany and Italy. Consider United Nations projections through 2050.
Working Age/Non Working Age China s Working Age Population Relative to Non-Working Age Population Source: United Nations 3 2.5 2 1.5 1 1980 1990 2000 2010 2020 2030 2040 2050
Will China slow down? China is beginning to slow down. That s bad news for everyone. China has been the growth engine for the world. With China slowing, two other BRICs are in even worse shape, Brazil and Russia.
Three of the BRICs have slowed down Economic forecasts for emerging markets Source: IMF, July 2016 2015 2016f 2017f China 6.9% 6.6% 6.2% India 7.6% 7.5% 7.4% Brazil -3.8% -3.3% 0.5% Russia -3.7% -1.2% 1.0%
B. Diversifying into alternative investments Hedge funds: Surely hedge funds provide an escape from the low returns offered by U.S. stock and bonds. Let s consider how well they have performed in the last 15 years.
Return per Annum Hedge Fund Returns Too Many Cooks Spoiling the Returns? HFRI Fund Weighted Hedge Fund Index 20% 18.2% 18.3% 15% 10% Decline Decline in in average average Decline in average returns returns Decline over over in time average time returns over time returns over time 5% 7.1% 5.7% 3.6% 0% 1990-1994 1995-1999 2000-2004 2005-2009 2010-2015
Diversifying into alternative investments Hedge funds: The increasingly poor performance of hedge funds in last 15 years is perhaps expected. After all, the space has been flooded by the influx of new funds. Are there that many arbitrage opportunities to keep 10,000 managers in business?
Diversifying into alternative investments Real Estate: Over last 20+ years as well as over the last 40+ years, real estate has outperformed U.S. equity. Look at REIT index relative to the S&P 500
Table 12-1 NAREIT and stock returns compared Average Return Standard deviation 1972-2015 NAREIT S&P 500 12.0% 10.3% 17.1% 15.2% 1992-2015 NAREIT S&P 500 11.2% 9.0% 19.1% 14.4% Sources: NAREIT and Standard and Poor s.
Diversifying into alternative investments Two caveats about real estate: 1. Real estate is as cyclically sensitive as stocks are. It s true that in the 2000-2001 recession, real estate did not fall with stocks. But in the financial crisis, the drop in REITs (65%) was more severe than in stocks (50%). 2. Current values in real estate ( Cap rates ) are high. It s not a great time to add to this sector. On other hand, the outlook is not great in any sector.
Index (Dec 1991 = 100) Crushed in financial crisis, but have come back fully Figure 11-4. NAREIT and S&P 500 Returns, 1992-2015 Data Sources: Ibbotson Associates and Zephyr Database 1500 1000 NAREIT S&P 500 500 0 Dec-91 Dec-97 Dec-03 Dec-09 Dec-15
Diversifying into alternative investments Private equity: Here we have an alternative investment that has proved itself time and again. Cambridge Associates has reported its private equity series since 1986. Returns have been consistently above those of the private equity markets. My advice to endowments (and wealthy families) wealthy enough to invest in PE: Take advantage of excess returns to buck the New Normal in public markets
Return Per Annum Private Equity Twenty Years of Superior Returns Source: Cambridge Associates 20% Private Equity S&P 500 16.8% 15% 12.2% 13.7% 11.1% 10% 9.1% 7.3% 5% 0% 1986II-1995 1996-2005 2006-2016I
Diversifying into alternative investments So private equity provides an alternative to the New Normal only for large endowments not for the rest of us.
The bottom line Investors face a New Normal of diminished returns. Economic growth has slowed throughout much of the world, so investment returns are likely to be lower than in the past.
My latest book published by Wiley Investing for a Lifetime Managing Wealth for the New Normal 1) Saving and Investing 2) Choosing a Portfolio 3) Wealth Management Also see my website richardcmarston.com