In our update of medium-term return expectations, we attempt to estimate the average nominal returns for the coming ten years of equities and bonds. The view is supplemented by volatilities and the ratio of expected returns to volatility.
The price corrections in the first half of 2022 on the equity and bond markets were very painful. After all, due to the now higher yields on bonds and the now lower valuations of equities, the medium-term earnings out-look has improved worldwide.
Periodically, at the beginning and middle of the year, we publish an update of our estimates of medium-term expected returns for various financial assets. We assume a long-term baseline return for each financial asset, adjusted for a reversion of its valuation to the mean. We refrain from using economic scenarios – rather, we assume that a typical economic cycle lasts ten years.
Assumptions for nominal earnings expectations
From 1802 to 2012, investors in US equities generated an average real total return of about 6.6 percent1 per year. Based on other studies, we also assume a uniform long-term return of 6.0 per cent per year in real terms for all the equity markets considered. Based on this, two adjustments are still necessary for the medium-term earnings estimate. On the one hand, the valuation of the stock market must be taken into account, and on the other hand, the level of the companies' profit margins (see appendix). Here we assume that both the valuation on the stock market and the profit margins of the companies return evenly to their historical mean over the period under consideration.
For the bond market, we assume that the real interest rate is the benchmark for valuation. Here, however, we do not assume a medium-term return of the real interest rate to the historical mean, but rather an approximation to the growth trend of the economy under consideration. The growth trend is the basis for being able to generate the real interest rate at all in the medium term.
For corporate bonds, high-yield bonds and emerging market bonds, on the other hand, we assume a return of spreads to the historical mean. We also take into account average credit default rates and recovery rates.
Current inflation expectations (inflation swaps) are then added to the estimate of real stock and bond returns in a next step to calculate the nominal return.
Finally, we estimate the cost of a currency hedge to convert the expected return on financial assets in foreign currency into euros. As a rule, a currency hedge is concluded for three months and then regularly renewed after three months over ten years. The costs of a currency hedge result accordingly from the average expected difference of the three-month interest rates over ten years. The uncovered interest parity also suggests that over the medium term the performance of an investment in foreign currency with or without currency hedging should hardly differ.
Large volatility differences in government, corporate and high-yield bonds and equities
Volatility is a measure of risk. Any investor will prefer an investment with an average annual return of 3 percent, which fluctuates between annual returns of 2 percent to 4 percent, to an investment with the same return but which fluctuates between annual returns of 20 percent to -10 percent.
Government bonds are considered the safest investment because a state with its own central bank can pay off creditors at any time. Changes in key interest rates in the economic cycle cause fluctuations in the prices of government bonds. The real risk for investors, however, is inflation. Historically, government bonds have the lowest volatility. In the US, there has even been a trend of falling volatility since 1980, which could be a consequence of lower inflation risks. Overall, the average annual volatility has been 5.0 percent since 1980.
Investment grade corporate bonds have greater risk than government bonds, as investors suffer losses depending on the recovery rate in the event of corporate bankruptcy. Accordingly, US investment grade corporate bonds have experienced an average annual volatility of 5.9 percent since 1980. High-yield bonds have a higher probability of bankruptcy and a lower average recovery rate. The higher risk was reflected in an average annual volatility of 8.9 percent since 1980.
Investors in shares bear the greatest risk, as they are at the end of a long chain of advance payments, wage payments, interest payments, tax payments, etc. and are only entitled to the surplus. They also often suffer a total loss in the event of bankruptcy. Since 1970, the annual average volatility of US equities (MSCI USA) has been 15.4 percent.
Low volatility until 2019 due to massive central bank interventions
The low volatility on all financial markets between 2010 and 2019 is striking. Obviously, the extensive interventions of the central banks ensure only minor price fluctuations. Volatility could thus remain low in the future. However, this is countered by the fact that even small changes in interest rates and/or risk premiums can theoretically have large price effects for equities and bonds in the current environment of low interest rates. The rapid price recovery of equities in 2020 has shown that this is not just theory. We therefore assume that, despite central bank intervention, volatilities will rise again towards historical averages. We have now put the return expectations over ten years in relation to historical volatility.
1 See Jeremy Siegel: Stocks for the Long Run
The real total return of an equity investment can be broken down into the following components:
1. Change in price-earnings ratio
2. Change in earnings per share
- Real sales growth
- Change in profit margin
- Change in the number of shares outstanding (e.g. due to share buybacks)
3. Dividend yield
In the long run, the real return on an investment in shares must correspond to the return on equity generated by the shareholding companies. Companies can use their return on equity to pay dividends, to buy back shares and to reinvest in the company. Therefore, the sum of real sales growth (as a result of reinvestment) plus share buybacks plus dividend yield must equal return on equity in the long run. We assume that companies worldwide generate a return on equity of 6 percent in the long run. Return on equity is a real measure (real sales growth plus change in number of shares outstanding plus dividend yield = constant = 6 per cent).
Furthermore, the price-earnings ratio and the profit margins of companies tend to move sideways over a very long period of more than 20 years. Over a ten-year period, however, profit margins and the price-earnings ratio are not constant but fluctuate. Here we use the simplifying assumption that a deviation from the mean observed today will correct itself again over a period of ten years.
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