Insights from Market Prognosticators: Emerging Market Stocks, Junk Bonds, and Inflation Forecasts
According to market seers, emerging market stocks are poised to outperform U.S. stocks, while junk bonds are expected to surpass high-grade bonds. Inflation is predicted to stabilize at 2.5%.
These prognostications stem from the release of capital market assumptions by major financial institutions. While experts largely agree on the outlook for emerging markets, junk bonds, and inflation, opinions diverge regarding the future performance of the U.S. stock market, which is perceived to yield lower returns compared to historical norms.
It’s essential to grasp the concept of expectations in this context. Rather than pinpointing specific outcomes akin to predicting the winner of a sporting event, expectations represent the midpoint of a probability distribution, acknowledging inherent uncertainty.
Financial firms undertake this exercise not to facilitate market timing, an elusive endeavor, but to aid clients in crafting long-term financial plans, especially concerning retirement preparations.
Of utmost significance are the insights into potential stock returns. While a simplistic view of investing relies on past performance—such as the 9.4% average annual real return of U.S. stocks over the last decade—this approach overlooks crucial factors. Notably, the market’s elevated price-to-earnings ratio has propelled historical returns to exceptional levels.
A recent analysis by an AQR Capital Management analyst sheds light on the unlikelihood of replicating the market’s past decade of robust returns. Even with earnings growing at an improbable 6% rate above inflation, sustaining such returns would necessitate an unprecedented surge in price-to-earnings ratios, surpassing even the highs of the 2000 tech bubble—a scenario deemed improbable.
Below, we present a selection of Wall Street forecasts, alongside a detailed examination of one method for estimating future stock returns. All figures denote real total returns, inclusive of dividends and adjusted for inflation, without factoring in taxes or portfolio management expenses.
HIGH-GRADE BONDS
Experts' expectations for total returns on U.S. fixed income, exclusive of junk.
| Company | Expected Returns |
|---|---|
| Schwab | 3.4% |
| Vanguard | 2.8% |
| Research Affiliates | 2.2% |
| Fidelity | 2.1% |
| GMO | 1.2% |
Fidelity’s forecasters are comfortably positioned with a 20-year horizon, as the anticipated return on inflation-protected Treasuries over that duration stands at just under 2.1%, a known factor.
In contrast, other firms are interpreting results based on a nearer time frame, considering an amalgamation of bonds, some long-term, and many slated for redemption and renewal. Changes in anticipated inflation or real interest rates could veer a portfolio’s returns away from current yields. Schwab anticipates a favorable shift in rates, while GMO foresees an unfavorable one.
INFLATION
Projections of long-term annual gains in the CPI.
| Company | Expected Returns |
|---|---|
| Fidelity | 2.7% |
| Research Affiliates | 2.6% |
| JP Morgan | 2.5% |
| Vanguard | 2.5% |
| Schwab | 2.3% |
| GMO | 2.3% |
The bond market expresses its outlook on future inflation, and forecasters largely align with it.
Conventional twenty-year Treasury bonds yield 4.6%, while twenty-year Treasuries with inflation protection yield 2.1%, indicating a 2.5% variance. Deducting a portion for the risk premium that conventional bondholders receive for shouldering uncertainty regarding future inflation, we arrive at a market forecast of approximately 2.4% for average inflation until 2044. The experts’ outlook is only marginally more conservative.
JUNK
Expectations for long-term real returns from what are politely known as high-yield bonds.
| Company | Expected Returns |
|---|---|
| Vanguard | 4.3% |
| JP Morgan | 4.0% |
| Fidelity | 3.7% |
| Research Affiliates | 3.1% |
The JP Morgan Beta Builders High Yield Corporate Bond ETF portfolio carries a yield of 7.8%. What does this translate to in terms of gains?
Firstly, deduct your anticipated capital losses from the coupon yield. These losses primarily stem from defaults, often resulting in a recovery of 50 cents or less on the dollar. Additionally, there’s subtle erosion due to bond covenants, where bonds from prospering companies are called away, leaving behind a concentration of bonds from struggling companies. According to a JPM white paper, capital losses are estimated at 1.5% annually.
Next, subtract inflation at 2.5% and the fund’s overhead of 0.15%. This leaves you with an expected return of around 3.7%.
Comparatively, this contrasts with the 2% offered by 10-year inflation-protected Treasury bonds. Investors in junk bonds receive compensation, albeit modest, for enduring uncertainty.
EMERGING MARKETS
Expectations for the stocks from China, India, Brazil and other sketchy places.
| Company | Expected Returns |
|---|---|
| Research Affiliates | 7.5% |
| JP Morgan | 6.5% |
| Fidelity | 5.4% |
| Vanguard | 5.1% |
| GMO | 4.3% |
The experts advise allocating some of your funds into emerging markets, where growth is robust and stock prices are relatively low.
This refrain is not new. A London money manager remarked sympathetically in 2012: “Fifty percent of the economic activity on the planet is in emerging markets. If you have 100% of your portfolio in the developed world you are taking a gamble.”
However, the outcome has been less than promising. Vanguard’s FTSE Emerging Markets ETF yielded a mere 0.7% annually over the past decade, net of inflation, significantly lagging behind the U.S. market.
Investing overseas comes with numerous risks: potential expropriations, tax implications, and rampant inflation. One significant concern is the “China syndrome,” where economic growth primarily benefits workers, consumers, the government, and insiders, leaving little for public shareholders.
Nevertheless, there remains optimism that experts’ predictions of emerging market stock outperformance might finally materialize.
Stock Returns: A Formula
Now, we’ll delve into a question that remained unanswered at the outset of this article: What constitutes the expected return?
Various market analysts employ different methodologies to arrive at this figure. Some augment the dividend yield on stocks with an estimate of capital appreciation based on GDP gains. Others project corporate earnings several years ahead, followed by an assumption regarding future price-to-earnings ratios. Yet another method entails discounting a stream of dividend payments.
Here’s a fourth approach: Emphasize the earnings yield. This method diverges significantly from those employed by typical Wall Street experts but yields a figure not too distant from the mainstream. Utilizing this method, I anticipate that stocks will generate a real total return of 3.3% annually over the next 40 years.
Should this projection materialize, the dollar invested in stocks at age 30 will have the purchasing power of $3.70 when spent at age 70. While this return is respectable, it pales in comparison to the gains enjoyed by today’s retirees. Since 1984, the market has averaged an annual return of 8.6%.
My 3.3% figure presupposes that the current elevated multiple of 26 times trailing earnings persists on a permanently high plateau. This would signify a departure from historical trends. Over the past century, the market’s average price-to-earnings ratio has hovered slightly above 14.
S&P TOTAL RETURN
A reinvested unit of the S&P 500 index would have grown in market value at a steep 7.5% rate over the past century (blue line). A constant multiple of average earnings over rolling 10-year intervals (orange) has a less exuberant slope.
Over the past century, the market’s modest multiples have translated into substantial returns, as illustrated by the blue line on the graph. But why? Let’s explore the arithmetic, consistently using inflation-adjusted dollars.
The price-to-earnings (P/E) multiple over the last century has had a harmonic mean of 14.4. Rounded, this equates to an earnings yield of 7%. In other words, an average corporation generated $7 of earnings for every $100 invested in it. Now, let’s make a simplifying assumption: if none of its profit were reinvested, a corporation’s earning power would remain unchanged. What could be done with the $7?
If the entire amount were distributed as dividends, shareholders could reinvest the money to purchase more shares. Assuming earnings and P/E ratios remain constant, the share price would stay steady. Consequently, the investor’s share count and wealth would grow at a 7% annual rate. The key point here is that the earnings yield equals the shareholder return.
What if the corporation doesn’t pay dividends? Instead, it reinvests the $7. It could allocate the funds to acquire more assets yielding the same 7% return, invest in other corporations for a 7% return, or repurchase its own shares for a 7% return. Regardless of the strategy, earnings would compound. Berkshire Hathaway employs all three strategies, albeit at returns lower than 7%.
The arithmetic remains consistent when the corporation, rather than the shareholder, reinvests. Earnings yield still equals shareholder return.
However, it’s not entirely accurate that corporations can reinvest nothing and maintain their earning power. They need to reinvest 14% of profits to sustain themselves.
Specifically, a hypothetical investor who bought stocks in 1924, reinvested dividends to acquire more shares, and then cashed in enough shares to extract each year’s corporate earnings, would have substantially diminished assets today. However, leaving 14% of each month’s earnings in the pot would have been sufficient to preserve earning power.
The S&P 500, currently trading at 5000, generated collective earnings of $191 per index unit last year. Adjusting for a 14% reinvestment deduction, this yields a $168 economic yield on a $5000 portfolio, equating to 3.3%—slightly lower than the apparent 3.8% earnings yield of the index. If P/Es remain constant, 3.3% is the expected return from stocks.
What if P/Es plummeted to historical levels next week? This would spell hardship for a retiree selling shares to cover expenses, but paradoxically, it would be advantageous for long-term investors. Faster compounding of portfolio earnings would more than compensate for the initial setback.
If the market’s P/E dropped to its historical average and remained low for 40 years, an investment just before the crash would eventually recover, turning a dollar into $6.40 of purchasing power in 2064 rather than $3.70.
This analysis doesn’t rely on special economic predictions; instead, it presumes corporate growth will continue on its historical trajectory. The past century witnessed severe profitability downturns but concluded with a period of low interest rates, reduced corporate taxes, and abundant Chinese labor. The neutral assumption is that corporations will follow the same average trajectory in the next century, with changes primarily in investor perceptions of a given earnings stream’s value.
Critics may find my forecast of permanently high P/Es reminiscent of Irving Fisher’s infamous bullish pronouncement before the 1929 crash. However, this plateau is not simply optimistic; it favors older investors while posing challenges for younger ones.
Many astute individuals disagree, suggesting that stock prices are poised to retreat to lower earnings multiples in the near future. This perspective underlies Research Affiliates’ projection of a lackluster decade for stocks and drives attention to Robert Shiller’s cyclically adjusted P/E ratio (CAPE), which compares prices to a trailing 10-year average of earnings. Currently high, CAPE, according to skeptics, often precedes weak returns.
However, it’s not a given that P/Es (as opposed to corporate profits) will revert to historical norms. The landscape of Wall Street has evolved. A century ago, stocks held a somewhat dubious reputation, unsuitable for orphans or endowments. Today, they’re viewed as more reliable stores of wealth over extended periods than inflation-vulnerable bonds. Twenty-first century investors may rationalize accepting an earnings yield barely over half of what it used to be.
Does a 3.3% return disappoint? You might achieve better results, but it shouldn’t be expected.