If we look past the market's most recent fixation on the possibility of fiscal stimulus, there's little to distinguish today's environment of sluggish growth and pedestrian returns from the similarly predictable rhythm of the past few years. But these unchanged conditions are deceptive and mask a period that's been characterized by groundbreaking monetary policy decision-making that has contributed to the paradoxes of our times — stock markets are surpassing highs despite persistent earnings weakness; the U.S. economic expansion is into its eighth year yet interest rates remain at rock bottom; and capital spending is weak, even though the cost of financing is at an all-time low.
In fairness to central banks, whose leaders found themselves tasked with drawing the global economy back from the brink, they've done a reasonable job smoothing the journey to achieve even this much growth. But, as they have learned only too well, in the field of human endeavor there may be no greater expression of “learning by doing” than the setting of monetary policy.
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 global economy — resulted in asset returns being borrowed from the future, and now that future is here.
Many asset owners benefited handsomely as quantitative easing turbocharged asset prices. But despite the cumulative years of monetary stimulus, growth remains sluggish and valuations are generally now rather high, suggesting leaner pickings for asset owners in the future. This predicament is unlikely to trouble central banks whose first responsibility is to the broader economy. So if the price of extending this shallow expansion is a glacial path of interest rate normalization and diminished future returns for asset owners, they might conclude it is well worth paying: easy come, easy go, perhaps.
The inexorable compression of returns comes, in large part, from the ability and willingness of central banks to act on the entire government yield curve and, in some cases, in corporate bond markets. The result of this, in asset return terms, is that duration is becoming a proxy for cash and investment-grade credit is becoming a proxy for sovereign duration. Nor does the stock market escape as equities — particularly those of the higher-quality, cash-rich companies with stable dividends — increasingly resemble corporate bonds.
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. Poor demographics and weak productivity combine to peg the longer-term outlook for developed market real economic 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.
But it is not all bad news. Based on a multidecade 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, credit markets should remain a relative bright spot in the fixed-income universe, particularly high-yield and longer-dated investment-grade corporate debt. Equities will also remain an important source of returns but with fewer rewards, and real assets are likely to hold up best in a world of challenged growth and lackluster returns.
A future in which returns are expected to be muted means that reaching the hurdle rate needed to meet long-term return 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.
John Bilton is London-based managing director and global head of multiasset strategy, J.P. Morgan Asset Management.
