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Why investors may need to lower their sights

Author: McKinsey Global Institute
Date: May 2016

Buoyed by exceptional economic and business conditions, returns on US and Western European equities and bonds during the past 30 years were considerably higher than the long-run trend. Some of these conditions are weakening or even reversing. In this report, we attempt to quantify the impact on future investment returns. Our analysis suggests that over the next 20 years, total returns including dividends and capital appreciation could be considerably lower than they were in the past three decades. This would have important repercussions for investors and other stakeholders, many of whom have grown used to these high returns.
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  • Despite repeated market turbulence, real total returns for equities investors between 1985 and 2014 averaged 7.9 percent in both the United States and Western Europe. These were 140 and 300 basis points (1.4 and 3.0 percentage points), respectively, above the 100-year average. Real bond returns in the same period averaged 5.0 percent in the United States, 330 basis points above the 100-year average, and 5.9 percent in Europe, 420 basis points above the average.
  • A confluence of economic and business trends drove these exceptional returns. They include sharp declines in inflation and interest rates from the unusually high levels of the 1970s and early 1980s; strong global GDP growth, lifted by positive demographics, productivity gains, and rapid growth in China; and even stronger corporate profit growth, reflecting revenue growth from new markets, declining corporate taxes over the period, and advances in automation and global supply chains that contained costs.
  • Some of these trends have run their course. The steep decline in inflation and interest rates has ended. GDP growth is likely to be sluggish as labor-force expansion and productivity gains have stalled. While digitization and disruptive technologies could boost margins of some companies in the future, the big North American and Western European firms that took the largest share of the global profit pool in the past 30 years face new competitive pressures as emerging-market companies expand, technology giants disrupt business models, and platform-enabled smaller rivals compete for customers.
  • As a result, investment returns over the next 20 years are likely to fall short of the returns of the 1985– 2014 period. In a slow-growth scenario, total real returns from US equities over the next 20 years could average 4 to 5 percent -  more than 250 basis points below the 1985–2014 average. Fixed-income real returns could be around 0 to 1 percent, 400 basis points lower or more. Even in a higher-growth scenario based on resurgent productivity growth, we find that returns may fall below the average of the past 30 years, by 140 to 240 basis points for equities and 300 to 400 basis points for fixed income. Our analysis shows a similar outcome for Europe.
  • Most investors today have lived their entire working lives during this golden era, and a long period of lower returns would require painful adjustments. Individuals would need to save more for retirement, retire later, or reduce consumption during retirement, which could be a further drag on the economy. To make up for a 200 basis point difference in average returns, for instance, a 30-year-old would have to work seven years longer or almost double his or her saving rate. Public and private pension funds could face increasing funding gaps and solvency risk. Endowments and insurers would also be affected.
  • Governments, both national and local, may face rising demands for social services and income support from poorer retirees at a time when public finances are stretched. 

Geography: Global

Type of study: Consulting research

Relevant for: All

Source: McKinsey Global Institute - May 2016

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