• While the global economy is looking better than it has for years, relatively low investment yields from most major asset classes mean the medium term return outlook remains constrained compared to the long term bull market in shares and bonds that started in the 1980s. For example, 7.5 to 8% pa for a diversified mix of assets, not double digits.
• For investors the implications are: have realistic return expectations; asset allocation remains critical; focus on assets providing decent and sustainable income flows. Australian shares still remain attractive for income flows but for growth Asian ex-Japan shares come out best.

Introduction

Most investment analysis and commentary is focused on the here and now and the implications for investment markets just a little bit ahead. But getting a handle on the return potential for major asset classes over the medium term, ie the next five years or so, is of value from several perspectives. First, such return projections are a critical driver of the strategic asset allocation (SAA) to each asset class (shares, bonds, property, etc) within traditional diversified investment funds.

Second, and more fundamentally, it gives a great guide to return potential between asset classes, which helps inform asset allocation generally. For example we use medium term return projections as part of our Dynamic Asset Allocation process.

Finally, it can help provide a guide to what sort of returns investors can expect beyond the short term. After a couple of years of double digit returns from shares and balanced growth superannuation funds there may be a temptation to assume we have now returned to a world of ongoing double digit returns. But this could be mistaken if it’s not sustainable.

This note takes a look at the medium term return potential for major asset classes and what that means for investors.

Getting a handle on return potential

The first thing to note is that simply taking a long term average of historical returns for each asset class and using that as a guide may be use, but often offers little guide to their medium term outlook given the significant impact of starting point valuations (eg, if current yields are significantly lower than normal then this will constrain returns relative to any long term norm) and the broad economic environment. Another approach may be to come up with a bunch of themes and start from there. But without a framework in which to place them this can simply lead to a muddle.

So our approach is to go back to basics, recognising firstly that the components of the return flowing from an asset are the yield (or income flow) it provides and capital growth and secondly that the starting point yield is key, ie, the higher the better. Then apply themes around this where relevant. We also prefer to avoid a reliance on forecasting and to keep the analysis as simple as possible. Complicated adjustments can lead to compounding forecasting errors without any value in terms of the broad message.

• For equities, a simple model of current dividend yields plus trend nominal GDP growth (as a proxy for earnings and capital growth) does a good job of predicting medium term returns. This approach allows for current valuations (which are picked up via the yield) but avoids getting too complicated.[1] The next chart shows this approach applied to US equities, where it can be seen to broadly track big secular swings in returns.

Source: Thomson Reuters, Global Financial Data, AMP Capital

• For property, we use current rental yields and likely trend inflation as a proxy for rental and capital growth.
• For unlisted infrastructure, we use current average yields and capital growth just ahead of inflation.
• For bonds, the best predictor of future medium term returns is the current five year bond yield. In other words capital growth is zero because if a five year bond is held to maturity its initial yield will be its return.

Medium term return projections

This framework results in the return projections shown in the next table. The second column shows each asset’s current income yield, the third their five year growth potential and the final column their total return potential. Note that:

• We assume central banks meet their inflation targets over time, eg, 2.5% in Australia and 2% in the US.
• We allow for forward points in the return projections for global assets based around current market pricing – which adds 1.8% to the return from world equities (Australian interest rates above that in other advanced countries) but detracts 1.9% from emerging equities.
• The Australian cash rate is assumed to average 3.5% over the next five years. This is one asset where the current yield is of no value in assessing the asset’s medium term return potential because the maturity is so short. So we assume a medium term average. Normally, for cash this would be around a country’s medium term nominal growth rate, but we have made an allowance to adjust for higher than normal bank lending rate margins over the cash rate and higher debt to income ratios which have increased the interest sensitivity of households, and in turn pulled down the neutral cash rate.
• The Australian equity return adjusted for franking credits (that adds about 1.4% pa) is shown in brackets.

Thematics

Several themes have been reflected in these projections:

• Low inflation – while inflation worries abound reflecting the quantitative easing programs of the last few years, this is likely to be offset by continued global excess savings and spare capacity along with central banks being mandated to meet inflation targets.
• Aging populations – resulting in slower labour force growth than seen over the last twenty or so years and a demand for yield bearing assets with less focus on capital growth.
• Slower household debt accumulation – the surge in household debt growth seen in the decades prior to the GFC looks to have run its course with tougher bank lending standards and more cautious consumer attitudes.
• The commodity super cycle has turned down – on the back of slower growth in China and increased commodity supply. This will act as a constraint on growth for some emerging markets (eg South America) but benefits commodity user regions (such as Asia, Europe and Japan). It also means the terms of trade has gone from a tailwind for Australian growth and profits to a headwind. To allow for this we have reduced nominal capital growth potential by 0.5% pa for Australian shares.
• Technological innovation – with its intensified focus on labour saving (eg robotics, 3D printing) it is likely good for productivity and corporate margins but ambiguous for consumer spending.
• Reinvigorated advanced countries versus emerging markets – while the emerging world still has a higher growth potential (reflecting its lower starting point) it’s likely to be slower over the decade ahead than last decade reflecting a slowdown in economic reforms but at the same time the US, Europe and Japan appear to be reinvigorating themselves after a tough decade (or two in the case of Japan).
• A multi-polar world – the end of the cold war and the stabilising influence of the US as the dominant power helped drive globalisation and the peace dividend post 1990. Now China’s rise and Russia’s retreat are arguably resulting in a more difficult environment geo-politically.
• Backtracking on free markets in parts of the world – a greater scepticism of unfettered markets and increased focus on regulation post the GFC.

Most of these will likely have the effect of constraining returns. But not universally so. Technological innovation remains positive for profits and the renaissance in the US, Europe and Japan is very positive.

Observations

Several observations flow from these projections.

• While advanced countries may have exited a secular bear market, return potential is still constrained. The starting point for returns today is less favourable than when long term bull markets started in bonds and equities in 1982 (with much lower investment yields today) & the thematic backdrop is less favourable. Our medium term return projections imply a 7.7% pa return from a diversified mix of assets. This is well below the 11.9% pa return Australian super funds saw over the 1982-2007 period which was underpinned by the combination of high starting point investment yields and very favourable investment thematics with the shift from high to low inflation, deregulation, easy credit, globalisation, the peace dividend, the IT revolution, favourable demographics and finally for Australia a surge in commodity prices.
• Sovereign bonds offer low return potential – after a thirty year secular decline in bond yields the combination of very low yields and the risk they will rise resulting in capital loss implies low medium term return potential.
• Unlisted commercial property & infrastructure continue to come out well reflecting their relatively high yields – but don’t forget their illiquidity.
• Australian shares stack up well on the basis of yield, but it is hard to beat Asian ex-Japan shares for growth potential and traditional global shares offer improved prospects.

Implications for investors

There are several implications for investors:

• First, have reasonable return expectations. The world is in far better shape today than at any time since the GFC but don’t expect year after year of double digit returns.
• Second, asset allocation remains critical reflecting: the relatively constrained medium term return potential; a likely wide range in returns between major asset classes; continued bouts of volatility (eg as extreme monetary policy conditions in the US and elsewhere are eventually unwound); and as the correlation between bonds and equities remains low (in the absence of a common driver like falling inflation provided in the 1980s and 1990s).
• Third, there is still a case for a bias towards Australian shares, particularly for yield focused investors, but with traditional global shares looking a bit healthier after a long tough patch have a bit more offshore. Asian ex-Japan shares are preferred relative to emerging market shares generally.
• Fourth, focus on assets providing decent sustainable income as it provides confidence regarding returns. Commercial property, infrastructure, quality yield shares and investment grade credit stack up well here.

Dr Shane Oliver, Head of Investment Strategy and Chief Economist AMP Capital

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[1] For example, adjustments can be made for: dividend payout ratios (but history shows that retained earnings often don’t lead to higher returns at the country level so the dividend yield is the best guide); the potential for PEs to move to some equilibrium level over time (but this relies on forecasting the equilibrium PE correctly which can be hard and in any case extreme dividend yields send a strong enough valuation signal anyway); and adjusting the earnings/capital growth assumption for some assessment regarding profit margins (but again this has been shown to be very hard to get right at the country level, eg US profit margins have been strengthening for decades and it’s hard to see what will turn this around). So we prefer to keep any reliance on forecasts to a minimum and to keep it simple.

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Determining a sensible strategic asset allocation is the key determinant of long-term performance, but it can be daunting. A retail investor selecting an appropriate portfolio for retirement savings or an institution investing on behalf of others is faced today with a bewildering array of choice. The options have expanded beyond recognition since a portfolio of government bonds was the norm.

The fundamental challenge when setting allocation policy is the lack of certainty about returns across the investment landscape. If we consider a simple stocks, bonds and cash portfolio, what can we say about likely returns for the next five years? Or the next 25?

A key point is that our assumptions must reflect reasonable beliefs about the future rather than simply mirroring the experience of the past. It is all too easy to take the last fifteen or twenty years of market data and feed it into an optimiser to come up with a recommended portfolio. However, unless we see an exact repeat of the same financial conditions and returns, this approach is highly unlikely to be optimal.

The performance of bonds in recent decades illustrates this neatly. Most of the major bond indices have their start date in the early 1980s, a time when government yields were in double digits. Since then we have seen yields fall to low single digits. The drop in yields has led to a steady tailwind of capital appreciation so that bonds have shown very strong returns both in absolute terms and relative to other asset classes. But with government yields of 2% or lower in the major economies, there is precious little prospect of matching those past returns from this starting point. A reversion of yields to their long term average would result in low or negative returns. Were we to use the last thirty years of the government bond index as a predictor of returns over the next thirty years we would be doomed to disappointment.

If we can’t use historical returns as the input for our modelling then what can we do? This is where some hard thinking is needed to create a robust framework for estimating future returns for asset classes and also their statistical distributions.

Many people choose to use a risk premium approach when addressing the question of returns. The idea is that investors are compensated for holding risky assets, so that over the long run they receive a greater return than they would achieve in a risk free asset. This additional return is termed a risk premium.

Historical analysis over a period of more than a hundred years and over several geographies suggests a defensible risk premium assumption for equities would be something like 4% a year over cash.
Does this mean that we should expect equity returns to be 4.5% over the next 12 months given a current cash rate of 0.5%?

No. The concept of risk premium only makes sense when considering very long periods of time. Equity markets are volatile and the chance of us seeing a 4% excess return in any 12 month period is slim. However, the longer the holding period the more confident we should be of achieving an annualised excess return over cash of this order of magnitude. 

History tells us that buying equities when they are expensive results in a significantly lower five to 10 year return than if we buy them when they are cheap.

However, we do not think it is right to factor current market valuations into long term return assumptions. It is a good discipline to think of long run return assumptions on the basis of money that will be invested five or 10 years from now when the situation is likely to be very different from today. This is helpful, because it allows us to separate opportunistic thinking from long term strategic thinking. If we take a long enough time horizon we can ignore short-term market dynamics.

In practice, we model strategic allocations over 40 years. While we can reduce the length of the modelling period, we have to recognise that this increases the variability of outcomes.

Forty years is a period consistent with the lifecycle of a typical worker making contributions into a pension scheme or with the sort of time horizon a sovereign fund storing wealth to distribute to future generations may have in mind. If one of the asset markets in our allocation is currently judged to be at an extreme then we aim to address this through a tactical asset allocation discipline which explicitly seeks to take positions according to shorter term inputs in order to generate additional return or to protect capital.

This approach allows us to be very clear about the proportion of the total portfolio held in a particular asset class that derives from long term considerations and how much derives from short term tactical positioning. Attempts to create a less well separated approach lead to a lack of clarity about exactly what role each percentage holding is playing in the portfolio and how its performance should be judged.
One area where timescale is at the forefront of the asset allocation question is ‘target date’ funds. These are funds where the investment manager explicitly manages the asset allocation to match the investor’s time horizon. An investor in their twenties saving for retirement should be able to tolerate a lot of equity risk. Their largest asset, when projected to the expected retirement date, is the value of contributions yet to be made. A bear market in equities would allow them to buy at lower prices and profit from the recovery, even if this takes a long time.

An investor in their sixties will not have the same tolerance for equity risk. If they have 100% exposure to equities just before retirement and markets fall significantly there is a real risk they will be unable to make good the damage done, either through a recovery in the market or through increased contributions. This argues for a far more conservative allocation.

So over a 40 year time period, the asset allocation should change from a more growth oriented portfolio to a much more conservative one. Many investors struggle to implement such a strategy unaided.
Asset allocation is the key factor in determining the performance and volatility of long-term investments. Deciding on an appropriate strategic asset allocation requires the consideration of a wide range of factors.

In a time when markets seem particularly unpredictable, disciplined asset allocation provides a way to generate more consistent returns at reduced volatility by taking calculated risks. The importance of experience and common sense as well as a robust and well considered approach to modelling should not be underestimated.

18 June 2012

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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