Expected Returns 2016-2020? Behind The Curve – The Price Of Normalization by Robeco Investment Solutions
For the fourth year running, Robeco Investment Solutions presents its Expected Returns publication. Another year gone, a new horizon up ahead. What should we expect for the world economy during the next five years, and how will that impact investor returns? Inflation, recessions, aging and the disruptive nature of new technologies: we have taken a critical look at a number of themes that might shape the world during the next five years.
Another year gone and a new outlook for the next five years is finished. Did the intervening year bring us what we had expected? Certainly not. We did not forecast oil to drop by USD 60 to below the USD 50 mark on account of the ongoing shale revolution. Neither did we forecast the subsequent return of deflation, which was the trigger for the ECB to launch an aggressive quantitative easing program. And indeed, we also failed to predict that Syriza would take political control in Greece, leading to the endless negotiations on debt reform and raising the prospect of a Grexit.
We could go on like this, because it is clear that we certainly missed many developments that have taken place since the publication of our last five-year outlook. The question however is: should we have tried to forecast these events in that publication? Certainly not. For one, the aim of this publication is to give a broad idea of the underlying developments in the world economy and financial markets on a five-year basis, not what happens over a shorter time horizon. We need another four years to see whether we made the right calls last year. More importantly however, it is incorrect to think that you can forecast to any degree of accuracy, let alone estimate the impact of certain events. Few could have predicted 9-11, nor what the longer-term impact would have been for the world economy.
This may raise the question of whether it is at all useful to try to say what the world will look like five years from now: we don’t even know what will happen in three months from now. The answer may surprise you, as it sounds counter-intuitive: for financial market returns, the longer term on average seems to be less uncertain than the short run. Partly this is related to the averaging out of the short-term fluctuations. This is clarified in one of the specials we present in this five-year outlook, which looks at the impact of recessions on returns. Added to this is the observation that valuation does not play much of a role in the short run, but does start to come into play on a longer-term horizon. Bonds that are currently expensive can become even more expensive in three months from now, but are unlikely to stay so for five years. The rally in European bonds, despite the fact that we already thought they were expensive last year, is a case in point.
Apart from these topics, we updated the outlook for the next five years, as well as the alternative scenarios. Compared to last year’s outlook we have raised the odds of our central scenario taking place (from 60% to 70%) at the cost of a reduced likelihood of the adverse scenario (from 30% to 20%). If we look at the characteristics of this central scenario, it is a logical update from the central scenario presented last year. At that time we expected to see a ‘gradual normalization’ of the world economy, with growth and inflation slowly returning to normal. We still believe this to be the most likely scenario. But as the leading economies in the world have moved closer to the point at which constraints will start to resurface, we have also moved into a more mature economic scenario. This scenario is called ‘behind the curve’. Higher growth, and yes, the return of inflation are the key elements.
Now we know that this ‘behind the curve’ scenario will lead to some raised eyebrows. Inflation, really? Ever since the Fed implemented the first quantitative easing program back in 2008, economists have been sounding the alarm bells with respect to inflation. Incorrectly, as it has turned out. The growth of money supply linked to the expansion of the Fed’s balance sheet has not led to the disastrous ‘rampant inflation’ that has been forewarned by some very respectable names. The accepted wisdom of leading monetarist and Nobel laureate Milton Friedman that ‘inflation is always and everywhere a monetary phenomenon’ has turned out to be not as simple as stated. Inflation has remained well-behaved, and is currently even below the longer-term target of 2% at the core level, well below the level at the time the first QE program was implemented. If a five-fold expansion of the balance sheet did not do the trick, why would inflation pose any threats now that the Fed has officially stopped expanding its balance sheet? Isn’t inflation officially a thing of the past?
To think that inflation is something that would just simply fall out of the sky once a central bank expands its balance sheet has always struck us as peculiar. Inflation is a process of firms raising prices, or labor demanding higher wages; processes which have no direct link with the money supply itself. No union will demand a wage increase because of the announcement of new QE program, and no company is deciding to raise prices on the basis of the latest money supply growth number: you need demand and shortages of supply for that. To stick to Friedman: inflation is the result of ‘too much money chasing too few goods’. So far we have seen a lot of money, but very limited chasing: most of the increase in the money supply has ended up as dead money on the balance sheets of the banking sector. All the chasing that has taken place has been in the financial markets. This is what we expect to be different in the five years to come: strengthening demand will result in economies running into capacity constraints again, which will trigger the re-emergence of inflation.
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