Several academic studies have determined that investors’ future return expectations are heavily influenced by recent performance. With the Canadian stock market delivering an exceptional 21.2% in 2016 and the U.S. market up 17.4% annually over the past three years, many investors are likely ratcheting up their return expectations.
But caution is in order. The sizzling returns of Canadian stocks were, for the most part, a recovery from the bear market of September 2014 to mid-January 2016. Over the past three years, the annualized return of the Canadian market was a more ordinary 7.4%. The stellar three-year U.S. market returns were primarily due to Canada’s plummeting dollar. In U.S. dollar terms, U.S stocks were up a solid, but not eye-catching, 8.6% per annum.
Yet, even this U.S. return is arguably on the high side for forming future expectations. Although Canada had a rough ride with the commodities bust over the past three years, the U.S. economy was in an expansion mode. A longer retrospective view that begins in 2006 when the U.S. unemployment rate was similar to today’s results in a more modest 7% annual return over the past 10 years.
Certainly, today’s valuations are not supportive of lofty future long-term returns. Even after allowing for a bullish earnings recovery in 2017, Canadian and U.S. markets remain fully priced. As of Dec. 31, 2016, the forward price/earnings (P/E) ratio for the Canadian market was 16.3 while that of the more expensive U.S. market was 17.9. International and emerging markets were more attractively priced with forward P/E ratios of 14.9 and 12, respectively.
With slowing population growth and declining productivity, future global growth prospects are middling. Aging developed nations, in particular, face real gross domestic product (GDP) growth rates in the 1%-2% range. Fortunately, more rapidly growing emerging markets have better prospects. Still, the Organization for Economic Co-operation and Development has forecast global annual real GDP growth of 3.1% per annum over the next 20 years.
Hence, future stock return expectations should be modest. This is reflected in the Financial Planning Standards Council’s (FPSC) Projection Assumption Guidelines for long-term financial projections. The FPSC’s 2016 report sets out annual return guidelines for Canadian equities at 6.4%; foreign developed-market equities at 6.8%; and emerging-market equities at 7.7%.
Investors’ recent experience with bonds is even more problematic for return expectations. Despite a challenging 2016, the Canadian bond market as measured by the FTSE TMX Canada universe bond index earned a 4.6% annual return over the past three years.
Unfortunately, past bond returns tell us little about future returns. Instead, the expected future nominal return of a high-quality bond is closely approximated by its yield to maturity. With today’s yield to maturity in the 2.2% range, Canadian investment-grade bonds will most likely deliver low single-digit returns over the next decade.
Low long-term equity and bond returns are the stark future facing investors. Advisors must incorporate these realistic assumptions in their clients’ financial plans, particularly for those facing retirement.
Customizing investment strategies, managing investment costs, reducing unnecessary taxes and assisting in proper budgeting are critical advisory functions in a world of uninspiring future returns.
Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment counselling firm.
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