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Expecting Returns?

Decomposing Forecast Returns

Where do return forecasts come from?

It would be simple to project historical returns forward. But investors were spoiled by the higher than normal returns of the 1980s and 1990s (and 2000s) that saw interest rates decline from about 20% to near zero. Interest rate declines provide tailwind for stock, bonds and real estate returns. Those interest rate declines are non-repeatable. (Recent) historical returns aren’t as applicable going forward.

Institutional investors use a ‘building block’ approach to produce asset class return forecasts (for the next decade, or so, as opposed to a ‘prediction’ for 2011, say). The methodology decomposes asset class returns into component parts. Input assumptions include market prices (the collective judgements of all investors). (Practitioners of this approach include: J.P. Morgan, UBS, Credit Suisse, BMO Economic Research).

The building blocks are straightforward.

Forecast Bond returns approximate current yields. Current ‘benchmark’ 10-year bond yields are 3.2% in Canada. 3.4% in the U.S.. Long term bonds yield a bit more. (However, prepare for a rise in short-term interest rates – and higher yields – as inflation eventually resurfaces. This can impact longer bond returns).

Forecast Real Estate Income Trust (REIT) returns decompose into income yield (~4%-6% says the National Association of REITs), plus rental / lease growth (tied to inflation) components. The Bank of Canada target inflation is ~2%. REITs are forecast to return, therefore, ~6%-8%. Current market yields for Canadian REITs are ~5% and ~3.5% for U.S. REITs.

Forecast Stock returns decompose into Dividend yield + Corporate earnings growth. Current Canadian dividend yields are ~2 ¼%. U.S. yields are ~2%. Corporate earnings growth is basically inflation @ ~2% plus GDP @ ~2%.  Stocks are forecast to return, therefore, ~6%.

GDP is expected to be below long-term trend (which is ~3% at home, ~6% overseas). Commodity returns reflect GDP growth. Rising commodity prices will cause inflation. The Bank of Canada target inflation band is 1% – 3% so inflation, when it arrives, will be managed, in part, by raising interest rates. Corporate earning, in aggregate, cannot grow faster than the economy. Credit Suisse adds a small premium to a stock portfolio with a value and/or a small cap tilt … based on evidence that, long-term, a value style and small cap tilt will outperform.

Recomposing the building blocks, the investor gets a forecast portfolio return of ~3%-8% depending on ones mix of Bonds, REITs and Stocks … and Emerging economies. NAFTA GDP 2011

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