Outsized return expectations

An FS Investments study found that investors expect an average market return of 7.0% over the next five years.¹ But as market dynamics have changed, a traditional 60/40 portfolio is unlikely to deliver the same level of returns that investors enjoyed over the past few decades.

What got us here won’t get us there

A closer look at the environment driving fixed income and equity returns can help us better understand what it would take to generate a total return of 7% or more going forward.

Low interest rates

Interest rates have gradually declined since the 1980s, but the pace accelerated after the financial crisis. In a low yield environment in which a balanced fixed income portfolio generates annual returns of 2%–3%,² the equity portion would need to generate returns of approximately 10% in order to achieve a 7% total portfolio return.

Where could interest rates go from here?

The impact of changing interest rates depends on a few factors, including the pace and size of interest rate changes. Slow, incremental interest rate changes tend to have a more muted impact on fixed income returns than rapid, large changes.

Rising rates
Rising rates would help those in search of income. However, since bond prices and rates are inversely correlated, the benefit of rising income may be offset by falling bond prices. This could potentially dampen a bond’s total return below its stated coupon.

Remain the same
In a continued low rate environment, the returns of a traditional fixed income portfolio would be driven nearly entirely by income rather than a combination of income and price appreciation. Today, a diversified fixed income portfolio yields approximately 2.3%.²

Falling rates
As interest rates fall, bond prices rise. Rising bond prices could offset the decline in income or, depending on the pace and size of rate declines, potentially enhance a bond’s total return above its stated coupon. However, falling rates would further exacerbate the challenge of finding income going forward.

High stock valuations

Periods of high equity valuations have historically been followed by relatively low future returns, with the inverse true for periods of low equity valuations. Assuming equity market returns over the next 10 years are similar to the historical average of around 5% per year when starting with valuations at current levels,³ a fixed income portfolio would need to generate returns of 9%–10% per year to achieve a 7% total portfolio return.

What could future equity returns look like?

When equity valuations have reached their highest level, as measured by the cyclically adjusted price-to-earnings ratio (CAPE), the average annualized return over the subsequent 10-year period has averaged just above 5% per year.³

High equity valuations may signal a decade of lower returns ahead³

For context, U.S. equity markets have remained firmly within the highest valuation level (fifth quintile) since 2013, sustained in large part by unprecedented monetary stimulus. While no one knows for certain what the future holds for stock market performance, current equity valuations suggest that investors might need to lower their long-term return expectations.