Investors Need to Reset Their Expectations for 2016

January 15, 2016

by Michelle Perry Higgins

The bulls are growing tired and it’s time for investors to reset their return expectations for 2016.

For the six-year period beginning in January 2009 until the end of 2014, the S&P 500 more than doubled. In 2015, the S&P 500 ground to a halt and was essentially flat for the year. In spite of last year’s tepid performance, many investors may still be hooked on the impressive returns of the last seven years. But will the markets rev up again in 2016 and beyond?

There are a number of reasons to believe that they won’t and investors need to come to grips with that possibility and how it may impact their portfolios and financial plans.

Several themes from 2015 that caused it to be a “lost” year for market returns have already been revisited in 2016. Chinese economic growth showed the first significant signs of slowing as the economy transitions from exports and infrastructure investment to a slower-growth, more consumer-oriented policy. The markets fear that the deceleration in growth will continue this year and possibly beyond. The Chinese economy has grown to such a size that, to paraphrase a saying that has been said about the U.S. economy, “When China sneezes, the world catches cold.”

In 2015, the dollar continued its slide relative to important global currencies including the euro and Chinese yuan. The strengthening dollar has had a three-fold negative effect: U.S.-made goods became more expensive in the global marketplace; the overseas earnings of U.S. companies became less valuable; and the value of foreign stocks in the portfolios of U.S. investors declined. The increase in the short-term interest rate in December of last year by the Federal Reserve makes it likely that the dollar’s strength will continue into 2016.

As a result of China’s slower and redirected growth as well as the dollar’s strength, commodity prices collapsed in 2015. This trend has continued in 2016, especially with respect to oil. Many experts believed that the decline in energy prices would spur consumer spending in the U.S. economy, but while auto sales have been robust, overall consumer spending has not.

With all these headwinds, market returns may very well disappoint again in 2016. But what about returns over a longer period of time? There are a number of reasons to believe that returns may be muted for a number of years. The effects of the Great Recession linger, characterized by the lowest labor participation rate in the U.S. in decades.

In addition, the developed world and China face demographic pressures that will both restrict the capacity of their economies to grow and impose increasing social welfare needs as the number of retirees grow relative to the working population. On another front, debt levels have risen to the point where expansionary monetary policies that worked in the past no longer have the same efficacy in boosting growth. Before December’s increase, the Federal Reserve had not raised interest rates since 2006. In the past, lower rates for such a long period would have spurred growth through private sector debt increase to fund economic activity. This did not happen after the Great Recession, forcing the Fed to resort to extraordinary measures such as Quantitative Easing.

In the context of a global slowdown characterized by both short-term and structural impediments and elevated market valuations, investors need to reset their expectations of equity and bond market returns. Whereas annualized returns from the S&P 500 since 1926 through 2015 are slightly over 10%, John Bogle and Michael Nolan Jr., project 6% U.S. stock returns and 3% bond returns over the next decade, according to Morningstar Inc.MORN +0.68%’s Rekenthaler Report. Thus a balanced portfolio of 60% stocks and 40% bonds would generate a return of 4.8% before inflation.  This is consistent with a 4.5% return forecasted by The Bank Credit Analyst over the same period. More realistic returns need to be used in financial plans. If lowered returns cause shortfalls in retirement, then options need to be explored to shore up the plan.

It is better to confront the possibility of lower returns now than down the road, when what were easier choices become harder choices.