|By: Sam Sivarajan J.D., MBA, CFP (UK), Managing Director, Head of Manulife Private Wealth Since the 2008 Credit Crisis, investors have endured a low-yield, low-growth environment. This Brave New World, unfortunately, is here to stay. In a recent discussion, David Dodge, the former Governor of the Bank of Canada delivered a sobering message that “low growth is the new normal.” According to economic forecasts, Canadian GDP is expected to grow at a tepid 1.7 per cent this year after an even weaker 1.2 per cent in 2015. A recent report by the McKinsey Global Institute (MGI) warns that the past 30 years was the “Golden Age” and that the next 20 years will look more like the 100 year average. This is due to a number of factors: (i) the scourge of high inflation has largely been tamed, (ii) GDP is not growing as fast as it was a few decades ago, (iii) interest rates are at multi-century lows and (iv) corporate profits are under pressure. As a result, MGI is forecasting US equity returns of 4 – 6.5 per cent per annum over the next 20 years – less than the 7.9 per cent per annum realized between 1985 and 2014 but roughly in line with the 6.5 per cent per annum average over the last 100 years. MGI believes the same reversion to the mean effect to be taking place in European equities and the fixed income markets.
Source: McKinsey Global Institute
So what does this mean for the average investor? It means that one has to be prepared to take greater risk to achieve the same level of return in previous years. An investor in 1995 that was looking for a 7.5 per cent return could have achieved it by simply investing it all in bonds. An investor in 2015 looking for that same 7.5 per cent return would have to limit their bond exposure to only 12% of the portfolio – and their portfolio risk (as measured by standard deviation) almost triples from 6 per cent in 1995 to 17.2 per cent in 2015. That is a sea change! Welcome to the low growth world!
Is it all doom and gloom? In a word, no. That low growth world is accompanied by a dramatic reduction in inflation. Consider that inflation in the US in 1995 was almost 3 per cent. Inflation in the US in 2015 was almost 0 per cent. So that three per cent drop in purchasing power means that on an after-inflation basis, the drop in return expectations is not nearly as bad as the headline numbers would imply. After all, 7.5 per cent return on bonds in 1995 with a 3 per cent inflation rate is lower than a 7.5 per cent return on a diversified portfolio in 2015 with a 0 per cent inflation rate.
Investors also need to realize that staying in cash or exclusively in fixed income in this environment is a sure-fire way to erode real wealth after taxes and inflation, low as it may be, is taken into account. We recommend that investors (i) use a goals-based approach to design portfolios that can achieve their goals even in a low-growth environment, (ii) take a patient long-term approach with their investment portfolios and (iii) diversify across geographies and asset classes.