Investing is all about the future. When allocating assets, investors balance expected future returns and risks of different asset classes, such as bonds, equities, and commodities. These expectations are typically based on historical performance.
Preparing for 2016, we are taking a long-term look back at interest rates and bond returns in the U.S. There are two important, somewhat contradictory considerations. First, the future is unknown—anything can happen—so investors should consider all available history when weighing possible investment outcomes. Conversely, the world changes over time. The economy evolves, innovation causes changes, and experience builds knowledge. This leads to the difficult question: Do we blindly accept that history may repeat itself or do we have some level of confidence that we have learned from history and are less likely to repeat the worst mistakes?
When considering the 2016 outlook for bonds, particularly in the context of the history of economic performance over the past 65 years, what are prudent expectations? In Chart 4, we show long-term U.S. Treasury yields and annual total returns back to 1950. From 1950 through 1981, yields were rising as inflation rose and the U.S. suffered through the Korean War, the Vietnam War, questionable fiscal and monetary policies, the Arab oil embargo, and price controls, just to name a few. During that time, returns on bonds averaged just 3.2 percent. Since peaking in September 1981, Treasury yields and inflation have fallen. Average returns over 1982–2015 have been a much more robust 9 percent.
This raises an important question for investors: Is it prudent to expect high single-digit returns on bonds given that current yields are already at multi-decade lows? Our view is that low single-digit returns are more likely over the coming years and that investors should be careful when making bond allocations.
A healthy economy should provide a solid foundation for sales and earnings growth. With our Leaders index moving back into positive territory, the risk of recession remains low. However, with the global economy weak and the dollar relatively strong, the U.S. increasingly depends on domestic sources, primarily consumer spending and business investment, to drive growth. That makes policy tightening as we head into 2016 a bit of a risk. Despite that, we see the underlying economic fundamentals generally supporting future sales and earnings gains.
Our view seems to be shared by equity analysts. Consensus 2016 earnings estimates for the companies represented in the Standard & Poor’s 500 index of stocks are a combined $126.55 per share. That represents an 18.6 percent increase over the $106.69 per share expected for 2015. Over the long term, operating earnings for the S&P 500 have grown around 7 percent annually, about the same as the long-term price appreciation for the index (Chart 5).
The other major component in our analysis is valuation. While there are many ways to value equities, one of the simplest and most common is the price-to-earnings (P/E) ratio. By our calculation, the current P/E for the S&P 500 is 19.5. Since 1985, the P/E ratio has ranged between 11 and 30, with an average of 18.2 and a median of 17.2. If we exclude months where inflation was above 3 percent (high inflation tends to depress valuations), the average rises to 19.1, while the median increases to 17.8. That suggests that in the current low-inflation, moderate-growth environment, the S&P 500 is close to its historical average valuation.
Overall, we see the prospects for equities as neutral to mildly positive based on a P/E ratio close to the long-term average and continued growth in earnings, supported by moderate economic expansion.