Investment returns in the U.S. and Western Europe over the next 20 years will likely fall short of the returns of the previous 30 years, and investors should scale back their expectations as a result, said a new report from McKinsey Global Institute.
In the report, McKinsey cites many of the trends that occurred between 1985 and 2014 that supported a kind of “golden era” that has now run its course. Among those trends were the sharp declines in inflation and interest rates from the high levels of the late 1970s and early 1980s; strong growth in global gross domestic product driven by rapid growth in China, along with overall positive demographic changes and gains in productivity; and also very strong corporate profit growth.
Another reason is the historically low stock valuations at the beginning of that time period, said Timothy Koller, principal and co-author of the report, in a telephone interview.
“Inflation and interest rates were starting to come down, but investors were still quite concerned whether inflation was knocked out of the system or not,” Mr. Koller said, “and as a result of that, stock valuations were extremely low during that period of time by any historical standard going forward.”
The report said the period from 1985 to 2014 in the U.S. and Western Europe was an exceptional one, with real total annualized returns for equity investors of 7.9% in both regions, with the U.S. 1.4 percentage points above the 100-year average and Western Europe 3 percentage points above the average.
Bond returns, meanwhile, averaged 5% annually in the U.S., 3.3 percentage points above the 100-year average, and 5.9% annually in Western Europe, 4.2 percentage points above that average.
Under a slow-growth scenario, McKinsey projects U.S. equities could average between 4% and 5% annually in the next 20 years, while fixed-income returns could be between zero and 1% annually. An optimistic growth-recovery scenario has U.S. equities at 6.5%, which is equal to the 100-year average, still well below what state and local government pension funds project, Mr. Koller said.
Mr. Koller also noted profit margins over the past 30 years have kept returns extremely high.
“What has been driving the increase in margins during that period of time comes from globalization, more U.S. companies getting profits from overseas,” Mr. Koller said.
Now that valuations are more in line with where they should be, investors still seem to have what might be misplaced optimism that long-term returns will match the past 30 years, when they should likely look at the past 50 or 100 years, Mr. Koller said.
While it’s impossible to predict the expectations of individual investors, the published assumed rates of returns by state and local government pension funds may point to an overzealous environment, he said.
“They are expecting returns typically in the 7.5% and 8% range for a portfolio of stocks and bonds,” Mr. Koller said. “When you strip out the bonds and figure out what they would have to earn on stocks in order to achieve that return, you would see it’s mighty higher than what we’re projecting.”
A cause of that, Mr. Koller said, is because those funds are allowed to focus on the returns of the past 25 to 30 years rather than the last 50 to 100 years.