Global equity markets have proved to be remarkably resilient in recent weeks in the face of higher inflation, increases in interest rates and the economic disruption caused by Russia’s invasion of Ukraine.
But investors still face a long-term problem, as explained by Antti Ilmanen of quant-based investment firm AQR Capital Management in his new book Investing Amid Low Expected Returns. Investors have enjoyed strong realised returns because of falling yields across asset classes that have translated into significant capital gains. But yields cannot fall forever (indeed, bond and cash yields have started to rise). From these starting yield levels, real returns are likely to be low.
In the case of US equities, Ilmanen says that a simple dividend discount model suggests expected annual real returns of 3.2 per cent. That translates into about 5.5 per cent in nominal terms. That is a big problem for US public sector pension plans, which are counting on 7 per cent nominal returns from their portfolios (that usually include low-yielding assets such as bonds as well) to fund retirement benefits.