Investors can be forgiven for wondering how they are going to continue to make money in financial markets. Cash rates globally are low and are likely to remain so, especially in Australia. This article looks at a ‘back to basics’ investment strategy suitable for a low-growth environment.
The US Federal Reserve has been hiking cash rates. But despite talk of a post-QE (quantitative easing) investment regime, for most countries around the world, such as Australia, official interest rates and bond yields are low and likely to remain low. At the same time, rallies in many asset classes such as equities have pushed yields – and the return outlook – lower.
Investors still face a low-return environment. Income investors particularly face a challenging time, with the dividend cycle now maturing. Traditional dividend-paying sectors such as banks and telcos are struggling.
Investors may be looking at various strategies to enhance returns. But they should also be doing something else: going back to basics.
There are two known ‘knowns’ in investing – the equity risk premium and diversification -- that investors should keep in mind in this low-return environment. If they can understand them they will be better placed to generate higher returns and ultimately reach their investment goals.
1. The equity risk premium
The equity risk premium (ERP) tells us that – based on overwhelming evidence over the longer term investing in equities delivers a return premium over cash and bonds.
Over the long term the premium varies. But since 1900 the realised ERP has averaged more than 3.75%p.a. for the US and close to 5.0%p.a. for Australia1.
We believe the appropriate ERP going forward for developed market equities is approximately 4%. For Asian and emerging market shares it is slightly higher – at approximately 5.25% – reflecting greater volatility.
Markets are cyclical and the ERP, of course, depends on where investors buy.
If we look at equity valuations today there are few signs of extreme stress. Yes, the US market looks fully valued, but other markets, particularly Asian and emerging market equities, continue to offer reasonable value.
With cash rates and bond yields likely to remain low, and even with single digit-equity market returns, we believe investors will continue to be compensated for risk and equities should remain an asset class of choice.
That said, we can’t ignore the fact that equity market risk has increased as the valuation buffer has reduced. Before the global financial crisis Australian investors had for many years benefitted from the resilience and outperformance of local equities. But Australian shares have underperformed global markets in recent years, and we think this is likely to continue with growth being sub-par and the banks remaining under regulatory and competitive pressure.
While investors can count on the ERP, they shouldn’t put all their eggs in the equities basket. They should harness the power of diversification and invest in assets and strategies that are uncorrelated to equity risks.
There are a number of diversifiers:
- Government bonds: If economic growth falls, you typically see cash rates lowered, which reduces bond yields and increases their capital value. The longer the maturity or duration of the bond, the more price-sensitive it is to changes in the bond yield. Despite the current low level of yields, bonds will outperform equities in the event of a significant correction, providing some offset to losses.
- Currency: Investors should also consider diversifying based on currency because the Australian dollar usually falls when equity markets decline. So unhedged international equities will outperform – and help protect portfolios – during equity market slumps.
- Property and infrastructure: Both listed and unlisted property and infrastructure have some correlation to broader economic growth but are also linked to more specific factors such as supply/demand, inflation and cash rates. This means they can perform differently to equities.
- Private equity: Likewise, private equity is affected by economic cycles, but it is also influenced by the underlying manager’s capability in turning around and extracting value from businesses.
- Active management: Accessing value-add or active management in the market is another important diversifier to equity markets. While we recognise that there are some markets where the ability to source excess return is difficult, such as in the US equity market, there are other markets, like Australia, where there is strong evidence of the ability to add value.
- Dynamic asset allocation: Finally, you can invest in a portfolio which takes active decisions with regard to asset class weights within the portfolio. This is called dynamic asset allocation. This could mean moving the amount held in various asset classes within a narrow range, taking tilts to underlying countries/currencies/fixed interest markets/asset classes, or more actively changing the allocation between asset classes to significantly alter the risk profile of your portfolio, and therefore the factors that are likely to drive performance.
Portfolio construction to maximise returns
The key message is that in this current environment, portfolio construction is vital. Investors can improve their performance if they understand and implement basics such as the ERP and the role of diversification.
Portfolio construction, however, is a specialised skill that can maximise investors’ returns – even in challenging markets and there are a range of multi-asset vehicles available to investors that cater for differing risk appetites. In an environment where the ability to benefit from easy wins is behind us, and with the expectation that conditions will remain challenging, it can make sense to invest in a professionally-managed solution.
 Source: AMP Capital Market and Economics team, September 2018
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.