Investment returns are heading lower

Despite extraordinary highs and lows, returns were continually strong within the last 30 years, says McKinsey. Between 1985 and 2014, equity investors could, on average, gain 7.4 percent per year while bond investors faced returns of about 5 percent annually. Thereby, returns have easily outperformed their long-term average of the past 50 and 100 years. However, US and European equity and bond returns are becoming weaker within the next two decades. Economic and business conditions have changed, and investors need to adjust their expectations.

Using a model that links equity and bond returns directly to economic and business conditions, McKinsey has identified four principal factors driving investment returns: inflation, interest rates, real GDP growth, and corporate profit margins. More on the model and how factors have affected returns within the last 30 years can be found on mckinsey.com.

Generally, a steep decline in inflation and interest rates has driven exceptional returns. With inflation and interest rates being as low as today, they have no room to fall further. Therefore, they are unlikely to boost future returns.
A growing pool of working-age adults has fuelled growth in the past three decades. With an ageing population, employment growth will decline, leaving productivity as a growth driver. “But even if productivity were to grow in real terms at the rapid 1.8 percent annual rate of the past 50 years, the rate of global GDP growth would still decline by 40 percent over the next 50 years, so great is the decline in employment growth,” says McKinsey.
Finally, a more competitive environment will reduce corporate margins, especially in developed countries where businesses are threatened by newcomers from emerging markets, new technology companies and small and medium enterprises that are scaling using new technology platforms. Overall, after-tax profit margins could fall from 9.8 to 7.9 percent of global GDP.

In a first scenario developed by McKinsey, today’s slow growth environment continues with a real GDP growth of about 1.9 percent in the United States, employment growth of 0.5 percent and productivity growth of 1.5 percent. 10-year US government bonds will rise slowly to about 2 to 3.5 percent, and inflation will remain benign averaging at about 1.6 percent over the next two decades.
In this scenario, US real equity returns would average to about 4 and 5 percent over the next 20 years and fixed income investments could yield around 0 to 1 percent.

In a second scenario, growth recovers thanks to productivity accelerations. This leads to growth of about 2.9 percent per year in the US while companies are able to match their best-performing peers to maintain their margins.
However, even under this scenario, US equity returns will still be lower than in the three decades and amount to 5.5 to 6.5 percent. Bonds returns will generate about 1 to 2 percent yields.

“Investors in Western Europe should expect trends similar to those in the United States, though the magnitude of the potential fall in future returns is larger,” says McKinsey. Western European equity returns could amount to 4.5 to 5 percent in the slow growth and 5 to 6 percent in the recovery scenario.