Why We Rechecked Return Forecasts (And What We Learned)

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar.com. What does the recent market volatility mean for the long-term returns of stocks and bonds? Here with me to share what she's been hearing from some investment firms is Christine Benz. Christine is Morningstar's director of personal finance.

Christine, thanks for joining us today, Susan.

Christine Benz: Susan, it's great to be here.

Dziubinski: Every year you take a look at what some of the major investment firms, including Morningstar, is expecting in terms of long-term stock and bond market returns. Why do firms go out and make these forecasts every year?

Benz: Well, a couple of key reasons. One is that they are oftentimes managing portfolios themselves. So whether they're using strategic asset-allocation strategies or ones that are more tactical, they do have to have some sort of view on the returns for various asset classes. So that's a key reason. And then another reason is that many of these firms are providing guidance to financial advisors, individual investors, who in turn might use some of these forecasts to guide their plans.

Dziubinski: So how do you recommend that individual investors use these forecasts?

Benz: You definitely don't want to use any sort of tactical strategy because one thing we see is that even professional tactical asset allocators have a really difficult time making that work. But I do think that you'd need some sort of return assumption if you're doing financial planning. So if you know roughly what your portfolio will return, that in turn can tell you how much you need to save, or if you're in drawdown mode in retirement, it can help you figure out how much you can safely withdraw. So you do need some sort of return assumptions to do very basic financial planning. You need to plug something in. And then another reason why I often like to look at these forecasts is just because I think they provide an additional impetus to do something that's really good for our portfolios, which is to periodically rebalance. So if you're looking at these forecasts, you might see that the asset class you probably should be lightening up on may have fairly muted returns going forward. Whereas the one that has more robust-looking returns is probably the one that you would want to be adding to. So it just provides an impetus to do good portfolio hygiene.

Dziubinski: Now you've been gathering these forecasts from asset managers for the past several years, and you present them to our readers in an article usually in January. So, given that you did do that very thing, this past January, what made you want to go back and see if these firms had made any changes? Benz: Well, we really had a feeling that things had probably changed because of the extreme market volatility that we have experienced due to this pandemic. So of course we had the big equity market shock, which potentially depressed valuations. And I'll talk a little bit about that. And we also have seen high-quality bond yields drop significantly. So, those two factors made us want to check up on whether there were changes and indeed there have been.

Dziubinski: So let's start with U.S. equities. What sort of impact has the market volatility and the pandemic had on the forecasts there?

Benz: There's a comforting consistency actually when you look across forecasts from various firms. And I don't think it's sort of a "me too" sort of thing. I think that truly there is the view that because we have seen such volatility, even with recessionary fears on the horizon or potentially here already, there's a sense that valuations, depressed valuations today should lead to better equity market returns than was the expectation coming into this year. And that was true across all of the firms I looked at. But I would say, Susan, that no one should get too excited about the expectations for U.S. equity market returns. Across all of these firms, the expectation was generally low- to mid-single digits for U.S. equities. And some of these firms have an expectation that inflation could come back, which will gobble up some of that return as well. So, better-looking return forecast for U.S. stocks, but by no means exciting.

Dziubinski: And what we had seen in these expert forecasts during the past couple of years was that a lot of these firms were expecting foreign stocks, foreign equities to outperform U.S. stocks. Is that still the thinking? Has that shifted at all?

Benz: It's still very much the case. So I would say--I was talking earlier about the value of rebalancing--and I would say for equity investors, based on these forecasts, that looks like something to consider because across the board the return prospects for foreign stocks from these firms was higher than was the case for the U.S. So in most cases they were in mid- to high single digits for developed markets, foreign stocks. Some firms are much more optimistic about the returns for emerging-markets equities. So investors who want to make a play on that sector or potentially buy some sort of a fund that has encompassing developed- and emerging-markets exposure. To me, that seems probably like a smart thing to do.

Dziubinski: Now let's pivot over to bonds and what sort of changes there might be in the forecasts there.

Benz: Really, it's pretty bifurcated. So one thing we saw in the first quarter was great strength with high-quality bonds, and we've seen yields come way, way down, and that in turn has prompted most of these firms to really pull in their expectations for high-quality bond returns for the next decade. On the other hand, we have seen spreads widen, credit spreads, yield spreads widen, and so most firms do have higher return expectations for even high-quality corporate bonds but certainly lower-quality corporates as well. Those will obviously be accompanied by higher volatility, but it does seem like if you're willing to own a little bit of corporate bond exposure, maybe a dash of lower-quality bond exposure, you can accentuate your return a little bit as well albeit with a little more volatility.

Dziubinski: Christine, thank you so much for these updates today. This is great for perspective as we're evaluating our portfolios.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski for Morningstar. Thank you for tuning in.