What is the relation between economic activity and the stock market over the business cycle? This blog post presents some of the conclusions from my book From Main Street to Wall Street. One conclusion is that the business cycle has a strong impact on the stock market, another that post-1945 business-cycle dynamics are very different from pre-1945 business-cycle dynamics.
In this third part of my small four-part series of blog posts presenting glimpses of my book From Main Street to Wall Street, I turn to its examination of the relation between the stock market and the economy over the business cycle. It follows my first post (link), where I explained why I wrote the book, and the second (link), where I presented some of the book’s conclusions with respect to the long-run relation between the stock market and the economy.
The business cycle
In this part of the book, I explain what the business cycle is, what characterizes it, what causes business-cycle fluctuations in economic activity, and economic theories that explain business cycles.
Today, May 4, 2021, the Council for Return Expectations publishes its updated forecasts. We still expect very low – negative – returns on safe assets, though not as negative as we expected six months ago. We also expect marginally lower returns on risky assets. Compared to six months ago, we thus expect a lower equity risk premium.
I chair the Council for Return Expectations (link). Danish banks and pension companies use our forecasts when they project how their customers’ savings will develop. In this blog post from July last year (link), I describe the history of the council, who we are, why we publish expected returns, what they are used for, and so on.
Twice a year, we update our expectations. Today, we publish our latest forecasts.
My book – From Main Street to Wall Street (link) – has been published. This blog post explains why I wrote the book and its contents. The next three posts (that will be sent out in due course) will present some of the analyses and conclusions from the book.
start in 2008. The financial crisis was at its worst.
I was a young professor of finance. I studied financial crises (my Ph.D. is on currency crises) and the relation between the macroeconomy and expected stock returns.
During the last couple of weeks, yields have been rising and stock markets falling. Standard market turbulence is not interesting for this blog – stocks go up and down, most of the time up, and yields fluctuate – but intriguing (and expected) patterns characterize recent events.
Everybody seems to agree what is going on markets these weeks: Vaccines
are successful and being rolled out, so economies will open up soon, and Biden
will get his stimulus package to the tune of USD1.9tn. These two things (an
already strong economy when opening up and on top of that a large stimulus
package) will lead to very strong growth during the second half of 2021.
Inflation will rise and the Fed will have to tighten monetary policy. The
expected rise in inflation and the policy rate leads to increases in yields
today. This hurts stocks. These US developments spill over to other countries.
This story largely makes sense. Looking at the data, however, interesting outstanding issues remain.
It’s this time of the year. This post recalls events of 2020. It has been such an unusual year, so different from what we expected. Luckily, there seems to be light at the end of the very long and dark tunnel, and – I hope – that 2021will be considerably more joyful than 2020.
2020 started out so well. The roaring twenties and all that. Wuhan was a city I had not heard of, corona a beer people tell me is best served ice-cold with a slice of lime (I do not drink beer, tough I do enjoy wine), and social distancing words we would only get to know too well. Today, we know that Wuhan is a Chinese city with more than eleven million inhabitants and a marketplace where it presumably all started, corona also means something terrible, and social interaction is an activity we have come to miss so dearly.
Today, October 1, the Council for Return
Expectations publishes its updated expectations. We expect very low – negative –
returns on safe assets over the next five and ten years. We expect an equity
premium around 5-7 percent.
I chair the Council for Return Expectations (link). Twice a year, we update our expectations. Today, we publish our latest forecasts.
In a June post (link), I described the history of the council, how we operate, who we are, why we publish expected returns, what they are used for, and so on. Briefly, here, the Council consists of Torben M. Andersen (professor of economics, University of Aarhus; link), Peter Engberg Jensen (former CEO of Nykredit and current chairman of Financial Stabilitet; link ), and myself as Chairman. Based on inputs from Blackrock, J.P. Morgan, Mercer, and State Street (thanks!), we estimate expected returns, risks (standard deviations), and correlations between returns on ten different asset classes over the next five and ten years. We also publish expected returns on two assets classes (stocks and bonds) for investment horizons exceeding ten years.
The forecasts are important in
Denmark. When Danish pension funds project how the retirement savings of their customers
will most likely develop (with confidence bands), they base their projections on
the Council’s return expectations. Similarly, when banks advice Danish
investors on their non-retirement savings, they use the expected returns provided
by the Council. I think it is fair to say that Denmark has been a front-runner
in designing a system where banks and pension funds do not compete on expected
returns, but all use a
common set of return assumptions, determined by an independent Council.
forecasts published today will be used for pension projections and projections
for savings outside retirement accounts as of January 1, 2021. In spring 2021,
we will publish updated expectations that will be used from July 1, 2021, and
the following six months. And so on.
is as follows. The expectations we publish today are based on market data from
July 1, 2020. We use the period from July 1 until today (October 1) to
determine our expectations. The expectations we publish today are then used by
banks and pension companies as of January 1, 2021.
We publish forecasts for expected returns on ten asset classes over the next five years, years 6-10, and over the next ten years. Returns are average annual returns in Euros/Danish kroner (the Danish kroner is fixed to the euro). These are our expectations:
an investment in safe assets (defined as a five-year duration portfolio of 30%
Eurozone government bonds (minimum Triple-B), 20% Danish government bonds, and
50% Danish mortgage bonds – Danish mortgage bonds are triple-A rated, by the
way) to lose money every year on average over the next ten years. This is noteworthy.
On average, we expect such an investment to lose 0.1% per year over the next
ten years. Over the next five years, we expect it to lose 1.2% per annum. The
reason why we expect such low returns is that the underlying bond portfolio has
a duration of five years, as mentioned, and we expect a normalization of
interest rates, causing capital losses which drag down expected returns.
We expect lower returns from bond investments than we did in our June update (link). In June, we expected government and mortgage bonds to return a negative 0.3% per year over the next five years and a positive 0.3% per year over the next ten years. The reason why we expect lower returns now (-1.2% and -0.1% for the five and ten year periods, respectively) is that our forecasts today, as mentioned, are based on market data from July 1. On July 1, interest rates and credit spreads were lower than those used at our previous update. Our previous update was based on March 31 market data. In March, the corona virus had caused a hike in yields and a widening of credit spreads. Since then, yields and spreads have come down.
equities are expected to yield around 6% per year. This means that the equity
premium is expected to be 5%-7%, depending on the investment horizon.
low inflation. We expect Danish inflation to be 1.2% per annum over the next
five years and 1.5% over the next ten years.
investment horizons above ten years, we expect equities to return 6.5% per
annum and bonds 3.5%. This is the same as we expected last year (we update long-run
expectations once a year). Over the coming year, we will make a thorough evaluation
of these long-run expectations.
We also publish standard deviations for all asset classes and for all horizons, as well as correlations and fees. Standard deviations are high for high-return assets; nothing comes for free. We thus publish many numbers. You can find all these numbers on the webpage of the Council: link.
We (The Council for Return Expectations) expect that Danish investors will lose money – even before fees and inflation – if investing in safe assets over the next ten years. You can expect positive returns on other asset classes, but then you need to take on risks.
Historically, the risk-free real interest rate has been around 2% per annum and the nominal interest rate around 4%. Investors would see their savings grow, even without taking on risk. This is not what investors should expect going forward. The fact that you cannot expect your portfolio to grow without taking on risk tells us a lot about the low-return world we are living in.
The Council for Return Expectations published
its forecasts of expected returns last week. There is a wide dispersion across
asset classes. Returns on “safe” assets (government bonds) are expected to be very
low, even negative, on the short horizon, whereas emerging markets equities are
expected to return close to ten percent per year. The Council also publishes
forecasts for standard deviations, correlations, and inflation.
As one of my external activities, I chair the Council for Return Expectations (link). The Council estimates expected returns, standard deviations, and correlations on ten broad asset classes. The estimates are widely used in the Danish financial sector and public discussions. Danish pension funds use the estimates when they calculate pension projections for their customers and banks use them when they make projections for how outside-pension savings can be expected to develop. Newspapers also write about them, too.
I will argue that the Danish financial sector has been a front-runner in designing a way to make such independent return assumptions. I hope the set-up helps improving the credibility of the projections banks and pension funds make.
blog post, I present the latest estimates from the Council. As it is the first
time I present these estimates on this blog, I start out describing why the
Council was established, how the Council works, and the procedure we use in the
Council to find expected returns. Afterwards, I present the forecasts.
Background: The Council for Return Expectations
was established (under a slightly different name) two years ago. The background
was as follows.
Danes have large pension savings. Together with the Netherlands, Denmark has the largest pension savings in the world relative to GDP (We have a paper describing some of the key features of the Danish pension system here; link). Historically, pension savings have been guaranteed, meaning that pension holders were guaranteed a minimum average annual return on their pension savings. Because of low interest rates, longer life-expectancies, etc., Danish pension funds have shifted into so-called market-based pension products during the last decade or so. In these products, there is no minimum guaranteed return. This allows the pension funds to invest more freely, hopefully enabling them to secure higher risk-adjusted returns. Basically, you go from a constrained to an unconstrained (or at least less constrained) maximization problem, which should lead to a better outcome. However, when a pension holder is not guaranteed a minimum return, the expected pension payouts during retirement will obviously become more uncertain. The assumed expected returns and risks on the different assets that pension funds invest in thus become even more important (compared to a guaranteed pension product) for an individual’s expected pension payments during retirement.
A couple of
years ago, I was approached by the Danish pension industry and asked whether I
would help them design a set-up that could be used to generate expected returns
on pension funds’ investments. The result was the following: based on inputs
from international financial institutions, present expected returns over the
next ten years on ten different asset classes, as well as long-run (> 10
years) expectations on two assets classes (stocks and bonds), and update these
forecasts annually. The pension industry judged that an independent committee
should specify and regularly update the return expectations, in order to secure
arms-length. They asked me if I would chair this committee. The Committee is
now called the Council for Return Expectations
Last year, banks in Denmark asked whether we (The Council) would be able to expand the set of return assumptions. The background was – probably fair to say – a scandal in the largest bank in Denmark. Danske Bank had advised some of its customers to invest in an investment product that the bank itself expected would yield a lower return than a bank deposit. I.e., the bank had advised its customers to invest in a suboptimal product, given expected returns. It led to the resignation of the interim Danske Bank CEO (link). The Danish banking sector concluded that arms-length was needed in determining return expectations used for investments outside pension savings. They asked the Council if we could include return expectations for a shorter horizon (1-5 years, in addition to the 1-10 years horizon) and a more frequent update of the return assumptions (twice a year, instead of annually). These forecasts were published last week.
Procedure for determining expected returns
forecasts for nominal returns on ten broad asset classes. Having done extensive
research on the determinants of expected returns myself, I know that even
within a precisely defined asset class, forecasters can disagree substantially on
the outlook for the asset class. When designing the set-up, I thus suggested
that return expectations should be based on an arms-length principle and take
estimation uncertainty into account. We do this by basing our expectations on
inputs from several international investment houses.
Council) receive inputs from Blackrock, J.P. Morgan, Mercer, and State Street.
We are truly thankful for their help.
J.P. Morgan, Mercer, and State Street provide their estimates of expected
returns, standard deviations, and correlations on each of the ten asset classes
for each of the different horizons to the Council. The ten asset classes for
which we provide expected returns are:
Government and Mortgage Bonds
Emerging market sovereign bonds
Global equity (developed markets)
Emerging markets equity
nominal. Estimates are for the arithmetic average annual return per year during
the different horizons.
hedged into euros, i.e. are euro returns, except from emerging market equities
and local currency emerging market debt that are unhedged (emerging market debt
is 50%/50% local/hard currency). The Danish kroner is pegged to the euro, i.e. euro
returns are basically also Danish Kroner returns. Returns are before fees,
expect from the last four asset classes (private equity, Infrastructure, real
estate, and hedge funds) that are after fees to the funds that manage these
types of investments, but before the fees to the Danish pension/mutual fund
that in turn invests in the private equity funds, hedge funds, etc.
addition, we provide forecasts for Danish inflation based on inputs from a
number of Danish forecasters (the Danish central bank, ministry of finance,
The Council consists of three people: Torben M. Andersen (professor of economics, University of Aarhus; link), Peter Engberg Jensen (former CEO of Nykredit and current chairman of Financial Stabilitet; link ), and myself as Chairman. Our job in the Council is to specify the relevant asset classes and their characteristics, choose methods used to weight the inputs together, come up with reasonable forecasts, communicate these to the public, etc.
Forecasts of expected returns
The following table presents our forecasts of expected annual returns for the next five years, the next ten years, and years six through ten:
next five years, we expect “safe” investments (government bonds and Danish
mortgage bonds) to return a negative 0.3% per year on a pre-fees, pre-taxes, and
pre-inflation basis. This is a low return. On a net-of-fees, after-tax, and
real-terms basis, it is even lower. In the Danish media, much was written about
this number (-0.3%). For finance professors and professionals, the number is no
big surprise given low interest rates, but for ordinary investors, the
publication of numbers such as these from trustworthy sources helps communicating
the message that it is difficult to earn a decent return these days without
taking on risk.
On a more technical term, the return on this asset class is the return to a bond portfolio consisting of 50% Danish mortgage bonds (that are triple-A rated, as you probably know), 20% Danish government bonds, and 30% Euro government bonds, with a duration of five years.
There is a
wide dispersion across the different asset classes. For instance, we expect
emerging market equity to yield 9.5% per year. There is thus an almost
ten-percentage point difference between the expected return on the safest asset
class and the asset class yielding the highest expected return.
that we generally expect higher returns after five years. We expect higher
interest rates, causing capital losses and thus low returns during the first five
years, but then higher returns later on. This in itself helps raising expected
returns on other asset classes.
Council, we want to stress that estimates of expected returns are surrounded by
uncertainty. To the finance professionals, this is obvious (though, one might sometimes
have the impression that even professionals tend to forget this), but to the
ordinary investor, this is even more important to emphasize. The ordinary
investor might otherwise conclude that when expected returns on emerging
markets is 9.5% per annum, but government bonds are expected to yield a
negative 0.3% per annum, I better put all my money in emerging market equity.
We want to stress that this is a risky strategy. This ambition has guided us when
it comes to our estimation of standard deviations.
expected returns we present are constructed as simple unweighted averages of
the expected returns of Blackrock, J.P. Morgan, Mercer, and State Street,
asset-class by asset-class. They also provide us with their expected standard
deviations. We do not use the simple averages of these as our estimates of
expected returns, though. Instead, we regress the standard deviations we receive
from the investment houses on the expected returns received from the same
investment houses. The standard deviations the Council presents are then the
fitted values from this regression. The main objective we achieve by following
this procedure is that we make sure that there is a clear relation between risks
The standard deviations surrounding the estimates of expected returns are here:
We expect a 3.5% standard deviation of government and mortgage bonds (over the next ten years) whereas we expect a 29.6% standard deviation surrounding the estimated returns to emerging markets equity. There is thus a clear relation between expected risks and returns. This clear relation also appears from this graph that plots risks on the ten asset classes against their returns (1-10 years horizon):
say that the price we pay from estimating standard deviations in this way is
that some of the individual estimates of standard deviations might differ slightly
from market consensus. As an example, our estimate of the standard deviation of
global equity is around 14%. Market consensus probably is that this is a little
higher, at 16%-17%. On the other hand, the advantage we obtain from proceeding
in this way, as mentioned, is that we secure a clear relation between risk and
We also present correlations between expected returns. Here they are for the first ten years:
are simple averages of the correlations we receive from Blackrock, J.P. Morgan,
Mercer, and State Street, asset-class by asset-class. The main thing to notice probably
is that we expect all correlations to be positive. This is bad news for
investors, one might argue, but we saw this during the March turmoil. In March,
bonds and stocks both lost in value, i.e. bonds did not hedge the risk of
stocks. Our correlations reflect this.
correlations and standard deviations are used by the pension funds to calculate
confidence intervals surrounding the individual’s expected pension income. I want
to stress that it is advanced – and good! – that pension holders in Denmark not
only learn about their expected pension income but also the uncertainty
surrounding this expectation.
We expect the Danish rate of inflation to be 1.2% over the next five years and 1.4% over the next ten years.
All the numbers
All the numbers – means, standard deviations, correlations, for all the horizons, etc. – are available on the webpage of the Council (link). On this webpage, addition information about the Council can be found as well.
We live in low-interest times. Investors might be tempted to invest more risky in order to generate a decent return. But what are decent returns? And how much extra risk do investors incur when investing more risky? In most countries, you get one set of answers when you visit one pension fund/bank/financial advisor, but another set of answers when you visit a different pension fund/bank/financial advisor. This makes investors uncertain and do not help building trust between the financial sector and investors. The financial sector in Denmark has found a cool way of presenting independent/arms-length forecasts. I hope that other countries might be inspired from this way of addressing this important issue.
PS. In my last post (link), I wrote about a new paper I have written on the financial stability in the Nordics. The journal where the paper is published is now available (link). It contains my own article and articles on the banking union, bail-in debts, household debts, and macroprudential policy, as well as a number of enlightening discussions.