Journal of Financial Planning: June 2017
The “golden age” of investing provided more than three decades of strong investment returns beginning in 1982. Despite two steep equity market corrections in the 1990s, the S&P 500 Index (with dividends reinvested) provided double-digit annualized returns during the multi-decade rally. Bonds also rallied strongly, providing significant price appreciation as 10-year U.S. Treasury yields declined from double-digit to low single-digit levels.
Investors during the Golden Age benefited from market-friendly policy changes, favorable demographics, and increasing global trade. These positive factors served as tailwinds for stock and bond markets. However, many of the tailwinds are now becoming headwinds, and financial advisers and their clients will need to adapt to a less favorable outlook for markets.
Let’s further define the Golden Age, exploring the tailwinds before defining the headwinds, and consider some adjustments you can help your clients make to best invest in the post-Golden Age era.
Understanding the Golden Age
In 1980, the U.S. economy was burdened by stagflation, a combination of stagnant growth and high inflation. Real GDP growth was a tepid 1.3 percent in the prior year, and unemployment had risen to 6.3 percent. The inflation rate was nearly 14 percent, and double-digit inflation seemed to be a permanent burden for the economy. High inflation was a consequence of the costly Vietnam War, the “Great Society” increase in domestic program spending under President Lyndon Johnson, and the Arab oil embargo. Then-presidential candidate Ronald Reagan cited the economic “misery index” as one of the reasons to deny re-election to President Jimmy Carter.
The geopolitical environment was also challenging, with American morale sapped by the ongoing Iranian hostage crisis and the long-standing Cold War. Against the challenging economic and geopolitical backdrop, it’s understandable that at the time, few saw 1980 as a turning point for the U.S. stock and bond markets. In retrospect, however, the following important developments in 1980, and also later in that decade, helped plant the seeds for a Golden Age of investing:
Reagan Revolution. Two pivotal events leading up to the market rally of 1982 were the election of Ronald Reagan as president and the first full year that Paul Volcker served as Federal Reserve chairman. American presidents typically receive too much credit for bull markets and too much blame for bear markets (and he wasn’t the only president to embrace free-market policies during the bull market), but Reagan’s tax cuts and easing of regulatory burdens helped provide a market-friendly foundation for the U.S. economy. Reagan’s polices weren’t without controversy at the time, or with the benefit of hindsight today. Income inequality, stagnant middle-class incomes, and corporate misbehavior are considered by some to have roots in the Reagan-era economic policies.
Volcker tames inflation. Under Volcker, the Fed had remarkable success in “taming” inflation. Volcker’s actions were as controversial as Reagan’s economic policies, as the Fed took unpopular steps to reduce inflation. The “Volcker recession” caused unemployment rates to reach double-digit levels, but created a steep and sustainable decline in inflation. The taming of inflation provided the backdrop for the multi-decade bull market in bonds.
Rise of the baby boomers. Demographics were another tailwind for the markets beginning in the early ’80s and continuing through the Golden Age, with baby boomers in their peak earning and spending years. Baby boomers were a powerful force in the economy, dominating the workforce, buying houses, spending on durable goods, and creating innovative new companies.
Peace dividend. The markets received an additional boost with the fall of the Berlin Wall in 1989 marking the unofficial end of the Cold War. The resulting “peace dividend” provided an economic boost for the U.S. in the 1990s in the form of reduced defense spending. Markets also benefited from the reduction of tail risk, as fears of superpower conflict receded.
Globalization. Global trade increased during the Golden Age, helped by the end of the Cold War, the rise of China as an economic power, and the widespread belief that trade was a positive economic force that also promoted peace among nations. U.S. multi-national companies were significant beneficiaries of the increase in trade, growing exports while reducing production costs. Consumers also benefited from globalization, benefiting from a wider selection and lower prices for many consumer goods.
Innovation, disruption, and productivity. The Golden Age featured significant innovation and entrepreneurial activity that boosted markets. Technology was a central focus of the Golden Age, creating opportunities as well as disruption. Some of the best-performing stocks came from the ranks of technology companies that didn’t exist in 1980, and some of the worst-performing stocks were companies disrupted by technology-driven insurgents.
Understanding the Headwinds
Today, many of the tailwinds from the Golden Age are becoming headwinds. Understanding these headwinds will help advisers best guide clients’ investing decisions.
Inflation and interest rates. The Fed has taken extraordinary actions to prevent the U.S. economy from falling into a deflationary spiral. After several years of monetary stimulus, inflation is finally near the Fed’s 2 percent target. At current levels, there is more of a risk associated with rising interest rates and inflation than potential benefit from a decline in either.
Aging of the baby boomers. At the start of this decade, the ratio of Americans aged 20 to 65 to Americans aged 65 or older was more than 4.5 to 1. By 2030, the ratio is projected to decline to less than 3 to 1. Absent significant policy changes, the aging of the baby boomers will create significant budget challenges. According to the nonpartisan Congressional Budget Office, mandatory outlays, including entitlements such as Social Security, Medicare, and Medicaid, are projected to exceed 80 percent of federal revenues by 2030. When debt servicing costs are added to mandatory spending, the cumulative spending commitments are projected to be nearly 100 percent of federal revenues by 2030.
Geopolitical threats in a multipolar world. Terrorism is a continuing threat for the world, compounded by anarchy in “ungoverned” states in the Middle East and Africa, as well as the nuclear ambitions of North Korea and Iran. Risks of superpower conflict are increasing, given the rise of China and the expansionism of Russia. Consequently, defense and security spending is likely to rise in coming decades, making the peace dividend of the 1990s a distant memory.
“America First.” Trade was a dominant issue in the 2016 U.S. presidential campaign, and the expansion of trade that took place during the Golden Age is likely to reverse in coming years.
Valuations and public debt. The Golden Age started with equity valuations at depressed levels that were close to depression-era lows; valuations today are considerably higher, though below the peaks reached during the technology bubble. U.S. public debt to GDP was slightly more than 30 percent in 1980, giving Reagan considerable latitude to lower taxes. Trump has less fiscal room to lower taxes unless he cuts spending elsewhere, as public debt is now more than 75 percent of GDP.
Implications for Investing
Helped by the tailwinds described earlier, U.S. economic growth was robust for much of the Golden Age. Real GDP growth averaged 3.6 percent from 1982 to 1989 and 3.2 percent during the 1990s. However, the 2000s featured two economic downturns, reducing real GDP growth to less than a 2 percent average for the decade. Asset manager PIMCO coined the term “new normal” to describe an era of below-average economic growth. The three “Ds”—demographics, deficits, and debt—make it likely that the new normal will continue as a long-term reality for economic and market growth. Consequently, advisers and their clients will need to make some important adjustments in approach.
Revise economic growth and investment return expectations. Individual investors need to reset expectations for future returns, in a sense following the example set by pension funds that have lowered their expected rate of return on investments. Lowering return expectations doesn’t mean that returns will be negative, contrary to the more dire predictions by some commentators. The economy is still growing, as are corporate earnings.
Bonds may not be the only source of diversification for an equity portfolio. Bonds were a great diversifier during the Golden Age, dampening volatility and providing both income and capital appreciation during equity market downturns. With interest rates at current levels, bonds won’t be as effective a diversifier as was the case during the Golden Age. Bonds are likely to continue to deliver lower volatility, but with lower income and capital appreciation potential the diversification benefit will be diluted. Advisers should consider alternatives in addition to bonds to diversify client portfolios with high levels of equity risk. Many investors are supplementing their stock and bond portfolios with investments such as gold, private real estate, managed futures, and insurance-linked securities.
Save more, while managing costs and taxes. In a low-return environment, many clients will need to save a greater proportion of their earnings in order to reach long-term goals. In addition, managing costs and taxes can be the critical difference between investment success and failure. High-cost investments are easier to justify during periods when double-digit returns are commonplace, but harder to absorb when returns are in low- to mid-single digits. Managing the tax implications of investing may be equally important, as tax loss harvesting and a thoughtful approach to asset location are among the strategies that can enhance after-tax investment returns.
Find the right blend of active, passive, and factor-based investments. Index and factor-based funds are low-cost, tax-efficient options in many asset classes. However, index and factor-based funds aren’t necessarily the best solutions in all parts of the market. In some asset classes, index funds are arguably riskier than actively managed funds. Indexes are backward-looking, and bond indexes in many cases are constructed poorly. Most fixed-income indexes have inherent flaws, “rewarding” companies and countries that issue the most debt. Equity indexes in more dynamic segments of the market, such as emerging markets, may have too little exposure to future growth opportunities.
Blending active, passive, and factor-based investments may provide superior returns to an approach that exclusively focuses on one style of management. [Editor’s note: see Sam Pittman’s research paper, “A Model for Building a Lower-Cost Portfolio Using Active, Passive, and Smart Beta Products,” in this issue for more on blending active, passive, and factor-based investments.]
With an understanding of the tailwinds that created the Golden Age and the headwinds that are causing a less favorable outlook for markets today, advisers will be better positioned to make some adjustments in their approach and advice.
Daniel Kern, CFA, CFP®, is chief investment officer for TFC Financial Management (www.tfcfinancial.com) an independent, fee-only, financial advisory firm based in Boston. Prior to joining TFC Financial Management, Kern was president and CIO of Advisor Partners. He is also a former managing director and portfolio manager for Charles Schwab Investment Management.
Learn More: Webinar
Join Daniel Kern, and investment adviser David Edwards, founder of the Heron Financial Group | Wealth Advisors, as they discuss the impact of the “golden age” of investing in the “new normal.” Find out why financial advisers and their clients will need to adapt a less favorable outlook for markets, and how lowering return expectations doesn’t mean that returns will be negative. Their discussion is followed by a live Q and A, moderated by FPA Knowledge Circle host Roy Benton.
June 28, 2017 at 2pm ET: Journal in the Round: Investing after the End of the Golden Age
1 CFP CE credit, Free to members