Investment Strategy

By saving and investing today, most investors expect that they will be better off tomorrow. This is a reasonable premise. For this to happen, investments must, at a minimum, outpace inflation.

Stock returns have done a great job at outpacing the rate of inflation over time –generally speaking, by about 6 percentage points per year.

Bond returns also have outpaced inflation over time, but by a significantly smaller margin than stock returns. Treasury bond yields have exceeded inflation by about 2 percentage points, on average, going back to 1958.

Sometimes the relationship between inflation and bond yields gets thrown out of whack.

In high-inflation environments, it’s possible that bond yields might not keep pace with inflation. Today, we are in this type of abnormal environment – illustrated by the chart below, courtesy of JP Morgan Asset Management.

The blue line shows the yield history of the 10-year Treasury bond yield. The peak yield of nearly 16% was reached in 1981, which came during a period of very high inflation.

The average 10-year Treasury bond yield since 1958 has been 5.7% (blue line), and the yield at the end of January was 3.5%. This yield, referred to as the ‘Nominal yield’, is what the 10-year Treasury has paid bondholders in interest before taking inflation into account.

The grey line shows the same 10-year Treasury with its yield adjusted for inflation. The after-inflation yield is called the Real yield, and it has averaged about 2.1% over time.

However, with inflation running north of 5.6% today, and with the 10-year Treasury providing a Nominal yield of 3.5%, the Real (after-inflation) yield is negative, by about 2.1%.

This situation of bond yields failing to keep pace with inflation is unusual and unlikely to persist indefinitely.

Eventually, Nominal yields will move above the rate of inflation. But the adjustment process can be painful for bondholders.

This was apparent in 2022, when the US bond market fell by 13%. The steep decline was a function of the yield / price relationship for bonds. When interest rates move up quickly, bond prices and bond returns fall.

A significant course correction for bonds occurred last year. Even still, the bond markets and the path of inflation remain in flux today. It likely will take time to revert to a normal bond yield / inflation relationship.

Because of this uncertain environment, proceeding with caution in managing bond allocations is advised. 

Emphasizing short-term bond funds, which carry less interest rate risk than longer-term bond funds, and inflation protected bond funds, are two ways to mitigate the negative effects of higher inflation on the bond portion of a portfolio.

The corollary to “What Comes Next?” is “What Happens Years from Now?”

This is not an academic question. Big banks and investment firms typically invest a lot of time and money when trying to figure this out.

JP Morgan Asset Management, for example, compiles a comprehensive set of forecasts each year. More than fifty researchers are tasked with this project, and the report they recently produced runs more than 120 pages

These forecasts are commonly referred to as “Long Term Capital Market Assumptions”. This is a mouthful. It translates to researchers’ best guess on how stocks and bonds will perform over the next ten to fifteen years.

The good news is that updated long-term forecasts for 2023 have improved very significantly compared to a year ago. This holds positive implications for long-term financial planning purposes.

I’ll share with you a snapshot of the changes, then use an example to illustrate why this development is so significant for individuals’ financial plans.

The table below compares long-term return expectations at the start of 2022 with long-term return expectations at the beginning of 2023, based on JP Morgan’s data.

At first glance, the percentage changes for the long-term assumptions might appear to be modest, at 3-ish percentage points for stocks and 2-ish percentage points for bonds.

But seeing how these adjustments play out, and how the higher return assumptions enhance wealth over the long-term, are noteworthy.

Here’s an example.

Say a family has $500,000 to invest in a well-diversified portfolio. They select 60% large company US stocks and 40% US Treasury bonds for their long-term asset allocation and decide to rebalance at the end of each year. They will neither make additional contributions nor take withdrawals during the next 10 years.

Under this framework, how much should they expect to have at the end of the 10-year period?

Using the 2022 return assumptions, they would expect to earn 3.3%, on average, per year. To keep things simple, let’s say they earn 3.3% each year for the next ten years. This translates to $692,000 at year 10—for a cumulative gain of $192,000.

Using the 2023 assumptions, annual return expectations rise by 2.9 percentage points to 6.2%. This higher annual return assumption means their portfolio would grow to $912,000—for a cumulative gain of $412,000.

The 2.9 percentage point difference means the family’s gain is more than twice as much in 10 years’ time.

While an actual financial plan has far more variables that what was presented above, you can see from my example that an upward adjustment in return assumptions (similar to changes JP Morgan has made for 2023) can have a very meaningful impact on total wealth over time. 

The Economist magazine summed up the situation well, in a non-statistical way, in the Leaders section of their December 8, 2022 issue:

“This year’s capital losses, however, have a silver lining. If the downside of higher asset prices was lower expected returns, then by symmetry, future real returns have now gone up…

The new regime of higher interest rates and scarcer capital may seem like a shock, but for much of history these were the normal conditions for investors. It was the era of cheap money (that is now behind us) that was weird.”