Investors face the big trade-off between asset value and returns

That means it is more than 2 percentage points lower than the U.S. inflation rate, which jumped 3.9 percent in May, according to the U.S. central bank’s preferred inflation measure, the U.S. Index of personal consumption expenses.

In addition, investors risk suffering heavy capital losses if bond prices fall sharply, causing bond yields to rise from historically low levels. (Yields rise as bond prices fall.)

Budget deficits and accommodative monetary policy

This is a far from hypothetical risk, according to economists who believe bond yields will inevitably rise to reflect mounting inflationary pressures as global economic activity recovers.

They argue that these price pressures will be exacerbated by the large budget deficits currently facing most developed countries and the reluctance of major central banks to tighten monetary policy.

So far, investors have ignored the risk of interest rates rising to contain mounting inflationary pressures.

US President Joe Biden this weekend withdrew from his threat to refuse to sign the roughly $ 1 trillion ($ 1.32 trillion) bipartisan infrastructure deal unless the US Congress does also endorse a multibillion-dollar package focused on social infrastructure, such as child care and education.

Biden’s pullback has removed a major obstacle to the $ 1 trillion infrastructure deal that was reached last week, which increases spending on roads, bridges, railways, ports and more. US broadband networks over the next eight years.

But, so far at least, investors have not been deterred by the prospect of additional infrastructure spending in the United States, perhaps because the lack of ready-to-go projects means there are usually delays with such projects.

Investors can potentially profit from the appreciation of the currency.

Yet economists are struggling to explain why investors continue to be happy with a negative real yield on US 10-year benchmark bonds, even as US economic activity has rebounded strongly.

One possible explanation is that investors believe a massive fiscal and monetary stimulus will only bring a temporary boost to the US economy, and the longer-term outlook is for significantly higher economic growth and inflation. weak.

An alternative, and more plausible, explanation is that many large institutions – such as pension funds and insurance companies – have investment rules that require them to hold a certain proportion of their portfolio in bonds.

For these investors, US bonds appear to be a relatively attractive proposition, especially compared to the meager returns they can obtain on European or Japanese bonds. (Right now, the yield on 10-year German Bunds is minus 0.15%, while Japanese 10-year bonds offer a paltry yield of 0.05%.)

In addition, investors can potentially profit from the appreciation of the currency.

The Consensus S&P 500 earnings per share forecast for 2021 is now close to US $ 191, up sharply from US $ 167 at the start of the year,

The US dollar has strengthened following signs that the US central bank may soon begin to move away from its ultra-relaxed monetary policy, under which it purchases $ 120 billion worth of US government bonds each month. and mortgage backed securities, all with near zero interest rates.

A series of comments from senior U.S. central bank officials last week suggested that there is growing support for reducing some monetary support, and in particular for reducing monthly purchases of U.S. central bank bonds.

Against this, however, influential New York Fed chief John Williams argued last week that it was premature to start cutting back on the monetary support the U.S. central bank is providing to the economy.

U.S. investors in the stock market, meanwhile, have welcomed increased U.S. infrastructure spending, with the S&P 500 ending the week on a new record.

Investors were given tremendous encouragement as analysts raised their earnings guidance for 2021, to reflect the significantly improved economic outlook.

Consensus S&P 500 earnings per share forecast for 2021 are now close to US $ 191, up sharply from US $ 167 earlier in the year.

But investors also have some trepidation when considering the stock market in the future.

They know the easy money has already been made by selecting which companies would prove to be winners from foreclosure, which would benefit from ultra-low interest rates, and which would see their profits rise sharply as economies reopen.

And they are aware that the skyrocketing valuation of the stock market will translate into lower returns in the long run.

The latest seven-year forecast from GMO, the Boston-based fund manager and founded by legendary investor Jeremy Grantham, paints a grim picture of future returns for various asset classes.

GMO predicts that large US stocks will achieve a negative annual real return of 7.8% over seven years, while small US stocks will earn a negative return of 8.4%.

International equity returns will be slightly less dismal, with large international equities achieving a negative annual real return of 2.7%, while small international equities will generate a negative return of 1.6%.

Emerging value stocks appear to be one of the few bright spots, with GMO predicting that this asset class will generate a positive real annual return of 2.7%. However, this is less than half of the historic 6.5% real return on US stocks.

In contrast, GMO expects US bonds to generate an annual real return of minus 2.6 percent, while US cash will perform slightly better, with an annual real return of minus 1 percent.

Meanwhile, investors may find little joy in the commercial real estate market, where industrial real estate yields continue to set new records, while central bankers are increasingly concerned about the surge. global residential property prices.

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