Get Real- Focus on Real Returns

signCould we be on our way to join the “Deflation Club?” Yes, our U.S. inflation rates continue to drop. It’s now 0.8% on an annual basis after the Consumer Price Index (CPI) declined 0.4% in December. CPI is at zero for last nine months.

For those of us who remember buying cars and getting home mortgages between 1979-1981 when inflation was 12-13%, it’s hard to comprehend. For the last thirty years, inflation has averaged about 3% per year and since 1970 about 4% per year. Hard to believe inflation is now at 1%. Yes, someone moved our cheese again.

And, it’s not just us. It’s all over the world. The Eurozone and Switzerland both recently slipped into deflation. The U.K. isn’t far off. Japan, which imposed a large sales tax increase in mid-2014, suddenly has the highest annual inflation rate in the developed world at 2.4%.

Market expectations of inflation over long periods have a huge impact on asset valuations in four major ways.

  • Price valuations. When inflation is high (think 1979-1981), buyers are willing to pay almost anything for an asset, since it appears the item is just going to keep getting much more expensive. In low inflation or deflationary periods, buyers wait because the price may be coming down and secondly, because their take home pay may be stagnant or non-existent.
  • Economic growth. The Fed has targeted 2% inflation as the rate at which the economy can grow at a sufficient level without overheating or going into recession. As we have discussed in detail in prior blogs, continued low inflation or deflation can cause low GDP growth or recession. Last week, the World Bank reduced its prediction for global growth in 2015 from 3.4% to 3%.
  • Riskless government debt rates. At the close of business last Friday, the 10-year U.S. Treasury note was 1.84% and 30-year 2.44%. The European 10-year government bonds are even lower- Germany at .45%, France at .63% and Switzerland at -.13% per year.
  • Consumer confidence. The huge drop in oil prices, caused primarily by plentiful supply, should be a real boon for families. Yet, the VIX, a measure of expected volatility called the “fear index” jumped on January 14th. Major changes and uncertainty make investors skittish.

Hence, unusually low market expectations of inflation have a huge impact on investment returns. To begin with, the risk/reward principal applies to most any investment. You need to be rewarded for the amount of risk you incur. Since U.S. treasuries are considered “risk-free”, other investments must provide the likelihood of a great return in order for an investor to risk their money. This “risk premium” is the return for the investment over treasuries.

Historically, since 1970, stocks have grown at the rate of almost 9% while inflation has been a little more than 4% per year. Hence, there has been a 5% real return obtained by risking money and investing in stocks. For the same time period, bonds returned about 6% per year, 2% more than inflation. This represents a 2% real return.

So, mathematically, if inflation is 2%, it is very possible that expected returns on a diversified equity portfolio over a long period of time might be 7% and returns on a diversified bond portfolio might be 4%. If inflation is 1%, the nominal returns might be 6% and 3% respectively. And, if low inflation or deflation persists, economic growth can stagnant which further impacts price valuations.

Of course, no one can guarantee future performance. Furthermore, there have been periods of time in the last 40 years when real returns of equities were far greater than 5% and periods where real returns were negative. From 1968-1982, the average annual equity nominal return was 6% while CPI was up 8% per year, resulting in a minus 2% real return. From 1982 to 2000, the equity return was an 18% nominal return annually and a 15% real return per year on average.

Our clients know that we have recently been modifying our DWM/MoneyGuidePro financial plans to reflect this current reality. Inflation is no longer 4.22% per year and expected returns of a balanced portfolio that historically were 7.5% are not likely when inflation is 1% a year. The focus needs to be on real returns. Depending on the allocation of the portfolio, a real return of 2%-5% over inflation for a diversified portfolio of equities, fixed income and alternatives may be a reasonable expectation in today’s investment environment.

So, our cheese actually moved two ways. Both inflation and nominal investment returns have declined. However, real returns should continue in similar historical patterns over time unless low inflation or deflation cause economic growth to stagnate or decline which could further reduce both the nominal and real returns.