Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Poor millennials. Up to their ears in student debt. Facing stagnant wages. Beset by obscene housing costs in the big cities where they are most likely to land a job – if they can land a job, that is.

And now a high-profile consulting firm, McKinsey & Co., is adding to millennials’ woes with a Debbie Downer report that warns that millennials will have to work seven years longer or save twice as much in order to live as well in retirement as their parents. The reason, according to McKinsey, is that returns for U.S. and Western European stocks and bonds will be far lower over the next 20 years than they were over the previous 30 years.

Well, take heart Millennial Investors. Your futures are better than McKinsey would have you believe.

McKinsey is right that the expected returns from U.S. stocks and bonds -- as well as Western European bonds -- aren't encouraging from today’s vantage point. Interest rates are low in the U.S. and Western Europe, and U.S. stock valuations are high –- both famously bearish signals.

But, of course, those aren't the only regions you should consider, Millennial Investors.

Let’s start with the obvious fact that the investible world is much bigger than just the U.S. and Western Europe, and today the highest expected returns are found in those other regions. A common and straightforward way to estimate expected return is to look at current yields for bonds and normalized earnings yields for stocks.

On that basis, it’s true that expected bond returns in developed markets, including the U.S., are downright depressing. The yield on the Barclays US Aggregate Bond Index is 2.1 percent, and the yield on the Barclays Global Aggregate ex-USD Index is 0.8 percent. But venture out of developed countries and it’s a whole other world. The yield on the J.P. Morgan EMBI Global Core Index, an emerging market bond index, is 5.4 percent.

The outlook for stocks, too, depends on where you look. The earnings yield on the S&P 500 Index is just 4.5 percent (calculated using ten-year trailing average earnings, excluding negatives). But the rest of the world is considerably more promising. The earnings yield on the MSCI EAFE Index, which includes not only Europe but also Australia and the Far East, is 7 percent. And the earnings yield on the MSCI Emerging Markets Index is 9.4 percent.

Big World After All
Expected returns on stocks and bonds are more promising outside developed countries.
SOURCE: Bloomberg
Methodology: Bond yields are yield to maturity; stock yields are normalized earnings yield (calculated using ten-year trailing average earnings, excluding negatives).

Granted, emerging markets are more risky, but how much more? Presumably McKinsey would have had no problem investing in the U.S. 30 years ago. According to the IMF, the U.S.’s GDP was $4.6 trillion in 1986. By comparison, the five most represented countries in the MSCI Emerging Markets Index – China, South Korea, Taiwan, India and Brazil – are expected to have a combined GDP of $17 trillion this year according to IMF estimates, and we haven’t even considered all the other countries in the index.

If you recoil at the comparison of the U.S. 30 years ago to emerging markets today, check your home bias and your hindsight bias and think for a moment about what the U.S. was like in the early 1980s, with stagflation and crumbling cities and sky-high interest rates and stocks in the toilet. Was the U.S. a safer bet then than all the emerging countries combined today? I don’t think so.

Just as investors aren’t confined to the U.S. and Western Europe, they’re also not confined to this moment in time, and expected returns have been known to change dramatically. Consider that the earnings yield on U.S. stocks – as measured by the inverse of Robert Shiller’s well-known cyclically adjusted price-to-earnings ratio – was 3.6 percent in July 2007. It had more than doubled to 7.5 percent by March 2009.

There are many other examples. The earnings yield was 2.3 percent in August 2000 and then jumped to 4.7 percent by February 2003. And the earnings yield was 5.3 percent in January 1973 and ballooned to 12.1 percent by December 1974. Similar moves can be seen in other countries and in other types of investments. 

Constant Motion
Expected returns on U.S. stocks, as measured by earnings yields, are always in flux.
SOURCE: Website of Robert J. Shiller
Methodology: Inverse of cyclically adjusted price-to-earnings ratio.

These wild swings are a gift to you, Millennial Investors, when you're facing low expected returns. Very few investors are going to plunk all of their retirement savings into the market today. Instead, the vast majority will save and invest gradually over the course of a working lifetime.

So while savings invested in U.S. stocks (or U.S. or Western European bonds, for that matter) today may grow at a frustratingly low rate, just stay the course and keep saving, Millennial Investors, because over time those savings will inevitably benefit from a more fertile environment.   

To be sure, no amount of clever investing will ever take the place of dutifully saving for retirement. But if you broaden your view of what is an acceptable investment beyond the U.S. and Western Europe, Millennial Investors, and remain disciplined about investing regularly, I suspect that you'll blow right past McKinsey’s gloomy estimates.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net