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Why Market Returns May Be Lower and Global Diversification May Be More Important in the Future

Key Points
  • Market returns on stocks and bonds over the next decade are expected to fall short of historical averages.

  • The main factors behind the lower expectations for asset returns are low inflation, historically low interest rates and elevated equity valuations.

  • International stocks appear more attractive than U.S. stocks based on valuations, underscoring the importance of investing in a diversified portfolio.

Market returns on stocks and bonds over the next decade are expected to fall short of historical averages, while global stocks are likely to outperform U.S. stocks, according to our 2018 estimates.¹

This article provides a broad overview of the methodology used for calculating our capital market return estimates and highlights the importance of global diversification and maintaining long-term financial objectives that are based on reasonable expectations.

The main factors behind the lower expectations for market returns are below-average inflation (despite a recent rise in expected inflation), historically low interest rates and elevated equity valuations.

The reduced outlook follows an extended period of double-digit returns for some asset classes, as shown in the chart below. As such, now may be a good time for investors to review, and consider resetting, long-term financial goals to ensure that they are based on projections grounded in disciplined methodology and not historical averages.

Our estimates show that, over the next 10 years, stocks and bonds will likely fall short of their historical annualized returns from 1970 to 2017. The estimated annual expected return for U.S. large-cap stocks from 2018 to 2027 is 6.5%, for example, compared with an annualized return of 10.5% during the historical period. Small-cap stocks, international large-cap stocks, core bonds and cash investments also are projected to post lower returns through 2027. However, the expected annual return for international large-cap stocks is 7.2% over the next 10 years, which is higher than the expectations for U.S. large-cap stocks.

Here are answers to frequently asked questions about these market estimates:

Why are long-term estimates of returns important?

How do you calculate your long-term forecasts?

Why do you expect long-term returns to be lower than historical averages?

What could lead to higher returns?

Why do you expect international stocks to outperform U.S. stocks?

What can investors do now?

Why are long-term estimates of returns important?

A sound financial plan serves as a road map to help investors reach long-term financial goals. To get there, investors need reasonable expectations for long-term market returns.

Return expectations that are too optimistic, for example, could lead to a delayed retirement or make it difficult to pay for a big expense such as a college education.  If return expectations are overly pessimistic, too much may be saved in the nest egg at the expense of everyday living.

How do you calculate your long-term forecasts?

The long-term estimates cover a 10-year time horizon. We take a forward-looking approach to forecasting returns, rather than basing our estimates on historical averages.

For U.S. and international large-cap stocks, we use analyst earnings estimates and macroeconomic forecast data to estimate two key cash-flow drivers of investment returns: recurring investment income (earnings) and capital gains generated by selling the investment at the end of the forecast horizon of 10 years. To arrive at a return estimate, we answer the question: What returns would investors make if they bought these assets at the current price level to obtain these forecasted future cash flows?

For U.S. small-capitalization stocks, we forecast the returns by analyzing and including the so-called “size risk premium.” This is the amount of money that investors typically expect to earn over and above the returns on U.S. large-capitalization stocks.

For the U.S. investment grade bonds asset class, which includes Treasuries, investment-grade corporate bonds and securitized bonds, our forecast takes into account both the yield-to-maturity (YTM) of the 10-year U.S. Treasury note and a corporate credit risk premium.² We believe the future level of returns an investor will receive, even if interest rates rise, is reflected with YTM. YTM is the return an investor can expect to receive if the bond is held till maturity. Although cash yields are currently negligible, we believe cash will keep up with the rate of inflation over the long run. Our inflation rate forecast is the consensus forecast of economists

Why do you expect long-term returns to be lower than historical averages?

Three primary factors are behind the forecast for reduced returns: lower inflation, low interest rates and elevated equity valuations.

  • Low inflation. Inflation averaged 4% annually from 1970-2017. Our forecast is for inflation to average 2.2% from 2018-2027. This is a slight increase from last year. It is still, however, much lower than the historical average. When the rate of inflation is low, bond yields also have been low. That is because bond investors generally do not require as much yield premium to compensate for the erosion in buying power that inflation can inflict on a portfolio. For stocks, low inflation historically has meant low nominal (before inflation) returns.
  • Low rates.  Lower inflation generally means low nominal (before inflation) interest rates. This affects yields on everything from cash to 30-year Treasury bonds. By historical standards, we are also in an era of low real rates (i.e., rates after adjusting for inflation) and this is likely to continue because the consensus forecast for global economic growth is much lower. Low yields mean investors earn less from the fixed-income portion of their portfolios. Stock returns tend to be higher than bond yields due to the relatively greater risk in holding stocks. When bond yields are lower, stock returns tend to be lower.
  • Elevated equity valuations. Most equity markets appear to have moved considerably higher during 2017 than justified by their earnings growth expectations, resulting in high valuations. We acknowledge that current expectations for earnings growth are improving relative to previous years, in part due to the recent corporate tax rate changes in the U.S. and better economic growth prospects for many countries. However, we would like to see further evidence of earnings growth to justify higher returns on stocks going forward.

Curb Your Expectations and Consider Going Global

Schwab’s return forecasts for the next decade are lower than historical averages for five major asset classes.

What could lead to higher returns?

Returns could exceed our expectations if the U.S. economy grows more than economists anticipate. According to consensus forecasts, economists expect 2.1% annual gross domestic product (GDP) growth over the next 10 years, even after accounting for the recent corporate tax rate changes.  Higher-than-expected economic growth would likely lead to higher earnings growth, driving stock and bond returns higher. An example of the economy growing faster than expected occurred from 1990-1999. During that period, economists expected annual GDP growth of 2.4%, while the U.S. economy actually grew at a much higher rate of 3.2% annually on average. Corresponding returns from U.S. large-capitalization stocks were 18.2% on average and core bonds averaged 7.7% despite severe market turbulence in 1998.

Also, it is important to note that tax policy changes alone cannot support earnings growth. Corporations leveraging tax savings for long-term capital investments would be important to helping boost earnings on a sustainable basis, which would, in turn, lead to better return expectations.

Why do you expect international stocks to outperform U.S. stocks?

As shown in the chart above, U.S. large-cap stocks are expected to return 6.5% annually over the next 10 years, compared to a higher return expectation of 7.2% for international large-cap stocks. This is mainly due to the current elevated valuations for U.S. stocks compared to international stocks.

What can investors do now?

Thanks to the power of compound returns, what investors do (or don't do) today can have big implications on their ability to meet their long-term goals.

Here are a few things to consider doing. First, if you don't have a long-term financial plan, now is a good time to put one together. Second, try to minimize fees and taxes, particularly in a lower-return environment. And last but not least: Build a well-diversified portfolio.

 

¹ Charles Schwab Investment Advisory, Inc., a separately registered investment advisor and an affiliate of Charles Schwab & Co. Inc., annually updates the capital market return estimates.

² Treasury notes generate what is considered a “risk-free” rate, or yield, because of the negligible chance of the U.S. government defaulting on its debt obligations. A corporate credit “risk premium” is the amount of money that investors expect to earn above and beyond the yield because of the chance of a default by the corporation that issued the bond.

Next Steps

To discuss how this article might affect your investment decisions:

  • Call Schwab anytime at 877-338-0192.
  • Talk to a Schwab Financial Consultant at your local branch.

 

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Important Disclosures

All forward looking statements contained in this article, including any forecasts and estimates, are based on Charles Schwab Investment Advisory’s outlook only as of the date of this material.  Charles Schwab Investment Advisory, Inc. (“CSIA”) is an affiliate of Charles Schwab & Co., Inc. (“Schwab”).

Investing involves risk including loss of principal.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.  Data here are obtained from what are considered reliable sources; its accuracy, completeness or reliability, however, cannot be guaranteed.

Past performance is no guarantee of future results.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

International investments are subject to additional risks such as currency fluctuation, geopolitical risk and the potential for illiquid markets.

Small cap funds are subject to greater volatility than those in other asset categories.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixedincome investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

U.S. Large Cap total returns 

Standard & Poor's market-capitalization weighted index focuses on the large-cap segment of the U.S. equities market.  It consists of 500 widely traded stocks that are chosen for market size, liquidity, and industry group representation.  S&P 500 is a registered trademark of, and proprietary to, S&P Dow Jones LLC.

U.S. Small Cap total returns

Russell indices are market-capitalization weighted and subsets of the Russell 3000® Index, which contains the largest 3,000 companies incorporated in the United States and represents approximately 98% of the investable U.S. equity market.  The Russell 2000® Index is composed of the 2000 smallest companies in the Russell 3000 Index.  The Russell 2000® Growth Index contains those Russell 2000 securities with a greater-than-average growth orientation.  The Russell 2000® Value Index contains those Russell 2000 securities with a less-than-average growth orientation.  The Russell 1000® Growth Index contains those Russell 1000 securities with a greater-than-average growth orientation.  The Russell 1000® Value Index contains those Russell 1000 securities with a less-than-average growth orientation.

International Large Cap total returns

MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 22 country indices: Australia, Austria, Belgium, Denmark, France, Finland, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

U.S. Investment Grade Bonds

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS. The U.S. Aggregate rolls up into other Bloomberg Barclays flagship indices, such as the multi-currency Global Aggregate Index and the U.S. Universal Index, which includes high yield and emerging markets debt. The U.S. Aggregate Index was created in 1986, with index history backfilled to January 1, 1976.

Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The Global Aggregate Bond Index ex US excludes the U.S. Aggregate component.

Cash Investments

This index measures the total return equivalent of 3-month U.S. Treasury securities.  The index consists of the last three 3-month Treasury bill issues, based on the month-end rate.  Returns for the index are calculated on a monthly basis only. The index is published by Citigroup Index LLC.

Indexes are unmanaged, do not incur management fees, costs, or expenses and cannot be invested in directly.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Charles Schwab Investment Advisory, Inc. ("CSIA") is an affiliate of Charles Schwab & Co., Inc. ("Schwab", Member SIPC).

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