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Low real interest rates suggest low equity returns [ClearOnMoney]
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Low real interest rates suggest low equity returns

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Commentary

Low real interest rates suggest low equity returns

27 Feb 2013 by Jim Fickett

It is fairly obvious that a low real (adjusted for inflation) short-term interest rate (e.g. on Treasury bills) implies poor overall bond returns – not only are bond yields typically low to match cash yields, but rates are likely to rise, lowering bond values. More interesting is that low real short-term yields are strongly correlated with low returns on equities as well.

Earlier this month Credit Suisse released its Global Investment Returns Yearbook. The Yearbook is a compilation of a few articles based on extensive data in the Sourcebook. The Yearbook is widely available. The Sourcebook may be purchased for 300 Great British Pounds.

The first article in this year's release is “The low-return world”, by Elroy Dimson, Paul Marsh, and Mike Staunton, of the London Business School. Here I would like to focus on just one key result from that article, as described in the abstract above.

The result is based on market data for a 113-year period in 20 countries, covering, obviously, a very wide range of conditions. For the result in focus here, the authors have divided the history into successive, overlapping, 5-year periods and, for each period in each country, recorded (1) the real interest rate on short-term government debt at the beginning of the period, and (2) average bond and equity returns over the succeeding 5-year period.

To look at the correlation between real yields and investment returns, all results are assigned to percentile-ranked bins of real yields. That is, each 5-year period in each country is assigned to (1) the lowest 5% of all real interest rates, (2) real interest rates in the lowest 20% but not the lowest 5%, etc. The light blue line in the following graph shows the boundaries between these percentile groups. So the second group mentioned above, real interest rates in the lowest 20% of the sample but not the lowest 5%, was made up of real interest rates between -11% and -2.3%.

The bars in the chart show total returns for equities (dark blue) and bonds (gray). So, again taking the second percentile group from the bottom, when real interest rates were between -11% and -2.3%, equities returned, on average, 3.0% over the following five years, and bonds returned, on average, -2.0%.

There is a very clear correlation between real rates and returns in the following five years, for both bonds and equities. Low real interest rates go together with poor returns for both asset classes. Of course the usual warnings apply – correlation is not causation, and these are historical averages, so our current situation may or may not follow the trend. However this is a clear warning – equity investments under current conditions, where real interest rates are very low or negative in most of the developed world, are likely to yield poor returns.