Portfolio Solutions' 30-Year Market Forecast for Investment Planning (2014 Edition)
Each year, Portfolio Solutions® publishes a 30-year forecast for stock and bond market returns. There are two sets of return expectations in this report. One is the return expectation based on a real return. This is the pre-inflation estimate. The second is a nominal return. It includes an inflation expectation. The risk stated for each asset class is the estimated annual standard deviation of return.
This forecast is intended for making long-term asset allocation decisions rather than short-term tactical decisions. It’s not possible to predict short-term asset class returns. It is possible and even desired to forecast long-term expected returns. These numbers can be used to construct an asset allocation to fit your needs. They’re not perfect, but they are a starting point.
This 30-year expected real return forecast relies on five primary drivers:
- Market risk as measured by comparative price volatility does contain information about expected return;
- The Federal Reserve’s long-term target for US GDP growth forecasts corporate earnings growth that can be used to forecast stock market growth;
- Market-implied inflation based on Federal Reserve inflation target and the yield difference between long-term Treasury Bonds and long-term Treasury Inflation Protected Securities (TIPS);
- Current cash payouts from interest, dividends, and Real Estate Investment Trusts (REITs); and
- A subjective reading of market valuation using standard ratios, fiscal and monetary policy actions, tax 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 fiscal policy (tax and spend) as well as monetary policy from the Central Banks (inflation and employment control through interest rate manipulation). These artificial forces distort return expectations on a regular basis. For decades, the US economy has benefited from government deficit spending. In addition, artificially low interest rates created by Federal Reserve policy pushed investors into riskier assets and thus drive up valuations. Only in the long-term do all these factors play out.
Today, any credible assessment of future risks and returns has to take into consideration the unprecedented size of the US fiscal deficit and burgeoning Federal Reserve balance sheet. The 10-year Treasury is at a 3.0% yield despite continued bond buying from the Fed, which is double the yield from a low of 1.5% set in July 2012.
The long-term inflation expectations are 1.75%, according to The Federal Reserve Bank of Cleveland. That’s slightly below the Fed’s target of 2.0% inflation and leaves room for more monetary easing.
With lower inflation and higher rates during 2013, the real return on the 10-year Treasury is closing in on its historical average of about 2.0%. My forecast of a regression that real yield means it’s likely that the total real return on 10-year US Treasury will be slightly lower than 2.0% over our 30-year forecast.
The US equity market had the best year since 1997 by gaining over 30 percent in total return. According to S&P Dow Jones Indices, corporate earnings increase by 11.38% since 2012, which is faster growth than in the previous year. The price-to-earnings ratio (PE) of the S&P 500 increased from 16.49 to 19.11 due to the surge in prices. It’s a high valuation for stocks, but reasonable given an environment of financial repression created by the current monetary policy.
Stock prices will likely continue to trade at higher than historic average valuations for as long as the Federal Reserve remains accommodative. The most recent economic projections from the Federal Reserve show long-term inflation-adjusted economic growth between 2.2 and 2.4%. This is 0.1 percent lower than the Fed’s 2013 forecast.
Given the backdrop of higher stock valuation and lower expected GDP growth in the long-term, we have reduced our long-term real return outlook for large cap US stocks from the 5.4% estimate last year to 5.0% going forward. We’ve also lowered expectations for small-cap and value stocks. The popularity of these styles has attracted large cash flows in recent years and that tells us future expected returns may be lower.
There is always a caveat, and the fly in the ointment this time is corporate taxes. If the top corporate tax rate is lowered to 30 percent or less, the long-term expected return from US stocks will be higher than those stated above.
International equities are beginning to become interesting again. Developed markets underperformed the US equity market in 2013 and emerging market stocks had very difficult year. This may make foreign stock ownership more attractive that US stock ownership on a valuation basis. Our expected long-term return for developed countries remains at 5.4 percent. Emerging markets remain high at a 7.0 percent real return expectation, although that’s lower than prevision forecasts due to slower growth in emerging market countries.
The following table is provided for informational purposes only and not intended to be used for short-term market timing. 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.
Thirty-Year Estimates of Bonds, Stocks and REITs Assuming a 2.0% Inflation Rate
|Asset Classes||Real Return||With 2.0% Inflation||Risk* Estimate|
|Government-Backed Fixed Income|
|U.S. Treasury bills (1-month maturity)||0.1||2.1||2.0|
|10-year U.S. Treasury notes||1.9||3.9||7.0|
|20-year U.S. Treasury bonds||2.5||4.5||8.0|
|30-year inflation protected Treasury (TIPS)||2.9||4.9||9.0|
|10-year tax-free municipal (A rated)||2.0||4.0||7.0|
|Corporate and Emerging Market Fixed Income|
|10-year investment-grade corporate (AAA-BBB)||2.6||4.6||9.0|
|20-year investment-grade corporate (AAA-BBB)||3.3||5.3||10.0|
|10-year high-yield corporate (BB-B)||4.5||6.5||15.0|
|Foreign government bonds (unhedged)||2.6||4.6||9.0|
|U.S. Common Equity and REITs|
|U.S. large-cap stocks||5.0||7.0||19.0|
|U.S. small-cap stocks||5.3||7.3||22.0|
|U.S. small-value stocks||6.0||8.0||26.0|
|REITs (real estate investment trusts)||5.0||7.0||19.0|
|International Equity (unhedged)|
|Developed countries small company||5.7||7.7||22.0|
|Developed countries small value companies||6.4||8.4||26.0|
|All emerging markets including frontier countries||7.0||9.0||29.0|
|Source: Rick Ferri|
*The estimate of risk is the estimated standard deviation of annual returns, according to Morningstar.