The report’s authors, Steve Ambler and Craig Alexander, project a 1% rate of real return for risk-free investments like Treasury bills, forming an anchor for the returns on other financial assets, including bonds and equities.
“Economic growth theory implies that the risk-free real rate of return should be greater than the average rate of growth of per capita output over a multi-decade period,” says Ambler. “In other words, it establishes a long-term floor to riskless investment returns.”
In the Canadian context, the impact of an aging population is expected to lower the rate of growth in real income per capita to an average annual pace of between 0.75% and 1.35% over the next couple of decades. Taking the lower end of that range as a floor, the implication is that real risk-free investments can only be counted on to return close to 1%.
According to Alexander, “a real risk-free rates over the long term should be greater than the rate of real per capita growth. On this basis, the risk-free rate in Canada would be in the range of 1% to 2%, and the structural changes in the economy point to the bottom of that range.”
Assuming the Bank of Canada maintains its 2% inflation target, this implies that the Bank of Canada overnight rate and the yield on three-month T-bills should return to 3%.
“Today, pension managers would be thrilled with such a return on highly liquid, sovereign-grade assets, and it may seem odd discussing such a high rate at the moment,” he says. “Nevertheless, long-term investors, like pension funds, have a multi-decade investment horizon, and the analysis tells us they need to be braced for lower returns than in the past.”
A core issue identified by the authors is whether secular stagnation, where economic weakness and the inability of low interest rates to boost economic growth is the result of a fundamental change, and holds true over future decades. If so, economic growth could be lower than generally predicted, providing an even lower floor under the risk-free rate in the long run.
“If modern economic growth theory is validated, there will be a point when the real risk-free rate once again exceeds the pace of real per capita output growth,” conclude the authors.
When it does, the equilibrium level of risk-free rates will remain below their historical experience, which is consistent with expectations that the Canadian economy will experience only modest trend real economic growth, partly reflecting the impact of demographics.