Prepare For Lower Returns?

Craig Wong of the Canadian Press reports, Savers, pension plans should prepare for lower investment returns, C.D. Howe report suggests:

Retirement savers and pension funds should be prepared for lower investment returns than they had before the financial crisis, a report by the C.D. Howe Institute suggests.

Report authors Steve Ambler and Craig Alexander project a one per cent rate of real return for risk-free investments will form an anchor for the returns on other investments including bonds and stocks.

And while Alexander said that would imply a three per cent return on three-month treasury bills if the Bank of Canada maintains its two per cent inflation target — which would be well ahead of where rates are today — it would be below where it was before the financial crisis and even lower than in the 1990s.

Three-month treasury bills currently earn around 0.42 per cent, however the yield on the same investment was more than four per cent as recently as 2007.

“Today, pension managers would be thrilled with such a return on highly liquid, sovereign-grade assets, and it may seem odd discussing such a high rate at the moment,” said Alexander, a former chief economist at TD Bank.

“Nevertheless, long-term investors, like pension funds, have a multi-decade investment horizon, and the analysis tells us they need to be braced for lower returns than in the past.”

The report noted that an investor hoping to earn a seven per cent annual return won’t be able to do that without taking at least some risk. And with a lower risk-free rate than in the past, that means taking more risk to earn the same return.

The report said the lower risk-free rate will be due, in part, to the impact of the aging population that will weigh on the rate of growth in real income per capita.

With growth in real income per capita expected to average at an annual pace between 0.75 and 1.35 per cent over the next couple of decades, that means the real return on risk-free investments can only be counted on to be close to one per cent, the report said.

Alexander acknowledged that the real risk-free rate today is below the pace of real per capita income growth, but said if economic theory is validated that will change.

“The level of rates today are remarkably low, they are unsustainably low and ultimately there’s going to have to be a rebalancing, but when that rebalancing happens the level of rates is not going to go up to anything like we had before,” he said.

“What it is telling you is that returns on a balanced diversified portfolio could be something in the range of four to six per cent and that’s probably lower than many pension funds are hoping for.”

I don't agree with the part of rates being "unsustainably low" (more on that below) but agree that we're entering an era of lower returns. You can read the full C.D. Howe Institute report by Steve Ambler and Craig Alexander by clicking here. I embedded the conclusion below (click on image);


So what are my thoughts? Should savers, pensions, mutual funds, insurance companies, endowments, hedge funds, real estate funds and private equity funds expect lower returns in the future? You bet they should and there's a simple reason why, one that the folks in the financial services industry are increasingly worried about privately but dismiss publicly and it's called deflation (not the good kind either, I'm talking about a prolonged period of debt deflation).

I've been warning you to prepare for global global deflation for a long time and ignore the chatter on the end of the deflation supercycle. If you read the latest Fed minutes which were released on Thursday, you'll see for yourself why there's a sea change going on at the Fed, one where it's paying a lot more attention to international developments and how they influence the U.S. dollar and inflation expectations.

And as I recently discussed in the Fed's courage to act, the big surprise in 2016 might be no rate hike. And if we get another downturn, expect more quantitative easing or even negative interest rates if Federal Reserve Bank of Minneapolis President Narayana Kocherlakota manages to sway others on the perils of low inflation.

In fact, HSBC's Steven Major who has been nailing the interest-rate story, is out with a bold new forecast:

In client note on Thursday titled "Yanking down the yields," the interest-rates strategist projected that bond yields would be much lower than the markets expected because central banks including the Federal Reserve were reluctant to raise interest rates.

Major sees the benchmark US 10-year yield, now at 2.05%, averaging 2.10% in the fourth quarter, but then tumbling to 1.5% by the third quarter of 2016. He also lowered projections for European bond yields.

If Major is right, it throws a kink in the doomsday scenarios of bond bears like Paul Singer and Alan Greenspan both of whom have been making dire warnings on bonds without properly understanding the structural deflationary headwinds which keep driving bond yields lower:

• The global jobs crisis: Jobs are vanishing all around the world at an alarming rate. Worse still, full employment jobs with good wages and benefits are being replaced with contract jobs or part-time employment with low wages and no benefits.
• Demographics: The aging of the population isn't pro-growth. As people get older, they live on a fixed income, consume less, and are generally more careful with their meager savings. The fact that the unemployment rate is soaring for younger workers just adds more fuel to the fire. Without a decent job, young people cannot afford to get married, buy a house and have children.
• The global pension crisis: A common theme of this blog is how pension poverty is wreaking havoc on our economy. It's not just the demographic shift, as people retire with little or no savings, they consume less, governments collect less sales taxes and they pay out more in social welfare costs. This is why I'm such a stickler for enhanced CPP and Social Security, a universal pension which covers everyone (provided governments get the governance and risk-sharing right).
• Rising inequality: The ultra wealthy keep getting richer and the poor keep getting poorer. Who cares? This is how it's always been and how it will always be. Unfortunately, as Warren Buffett and other enlightened billionaires have noted, the marginal utility of an extra billion to them isn't as useful as it can be to millions of others struggling under crushing poverty. Moreover, while Buffett and Gates talk up "The Giving Pledge", the truth is philanthropy won't make a dent in the trend of rising inequality which is extremely deflationary because it concentrates wealth in the hands of a few and does nothing to stimulate widespread consumption (I know, we can argue that last point but for the most part, you know I'm right).  
• High and unsustainable debt in the developed world: Government and household debt levels are high and unsustainable in many developed nations. This too constrains government and personal spending and is very deflationary, especially in an era of fiscal austerity.
• Technology: Everyone loves shopping on-line to hunt for bargains. Technology is great in terms of keeping productivity high and prices low, but viewed over a very long period, great shifts in technology are disinflationary and some say deflationary. 

Go back to read my comment from earlier this week on the problems at Teamsters' pension fund where I discussed the limits of inequality and the need to bolster Social Security for all Americans.

U.S. companies are hoarding record cash levels, over $2 trillion in offshore banks, and the guys and gals on Wall Street are making off like bandits as profits hit $11.3 billion in the last six months. Meanwhile, most Americans are barely able to get by because they have little or no savings whatsoever.

Why is this important? Because apart from the weak international economy, there are important domestic structural factors ensuring more inequality and deflation down the road. In fact, when you look at the factors I discuss above, it's mind-boggling to think the Fed will make the monumental mistake of raising interest rates, even if it's a one and done deal. Now more than ever, the risks of deflation coming to America are just one policy blunder away.

This is why I agree with Gary Shilling, a well-known deflationista, the 30-year bond yield is going to 2% which is why he continues to be bearish on energy and commodities. Shilling has been forecasting low energy and commodities prices and lower rates for some time and believes the bull market in bonds isn't over yet.

I agree with Shilling over a longer period but in the near term we are witnessing a commodity rebound lifting world equities, all part of an October surprise where we're seeing strong rallies in emerging markets (EEM), Chinese (FXI), Energy (XLE), Oil Services (OIH), Oil & Gas Exploration (XOP), Metals & Mining (XME) and solar (TAN).

What remains to be seen is if these rallies in beaten down sectors are counter-trend rallies that will fizzle out quickly or part of a much bigger sector rotation back in commodities and energy.

One thing is for sure, with the Fed out of the way, smart money isn't worried about a looming catastrophe ahead and is instead betting big on a global recovery. But nervous investors who got pummeled in the summer selloff will use these rallies to take money off the table (click on image below):