Despite the latest surge in COVID-19 cases, economies globally are once again expanding and, notwithstanding the occasional extended lockdown, we believe there’s many reasons to remain confident that this growth can continue into next year. However, can investors expect the recent strong returns to also continue as the world returns to some version of a post-pandemic ‘normal’?
Certainly, the recently completed financial year was a good one for equity investors. The S&P/ASX200 finished the financial year up 29% – the second-best performance over a financial year since 1993.1
The speed of the coronavirus-induced recession across the world, the enormous scale of the response from governments and central banks, and the speed of vaccine development have conspired to produce both an extremely fast and strong rebound, helped by a low starting point, but fuelled by fiscal stimulus and a commitment to keep interest rates low. That’s helped supercharge rebounding equity markets and in several markets, indices have reached record levels in recent weeks2.
Can we expect more of the same? Will the next few years deliver returns which might not match 2021 but achieve something similar?
In our opinion the answer, in short, is no.
The 2021 financial year was remarkable in the sense that the size of losses in the ‘recession’ preceding it were not of the magnitude that we would see in a true economic recession, but the scale of the stimulus and central bank support was. The upshot of that is that we are faced with interest rates near zero, and with yields in some markets that suggest that future returns are likely to be much more modest.
Every month AMP Capital’s chief economist Shane Oliver and his team produce a set of expected returns (or ‘capital market assumptions’) for every asset class that a super fund member or investor is likely to hold.
He measures what you’d expect a mix of assets in a traditional balanced superannuation fund will return (on average p.a.) over the next five to ten years. That estimate today is 4.9%.3 This is the lowest it has ever been, and we would suggest it is significantly lower than most people would be expecting. (If we apply those returns to more defensively oriented funds, the measure falls away even faster).
Why is this?
The prime reason is interest rates. Fixed interest investments such as government bonds are, on average, a decent investment allocation of many investors’ portfolios. And most other asset classes, such as equities, are ultimately priced based on the rates of those ‘risk-free’ government bonds.
Over 30 years, we have seen bond yields fall from 11% to 1.1%4 today. Throughout that period bond prices have been ‘pulling forward’ future returns. History can’t repeat that performance from risk-free bonds, in our opinion. The best guide as to what bonds could deliver going forward is their current yield, and for an Australian 10-year bond that is approximately 1.1% per annum5, almost certainly a negative real return once inflation is taken into account.
In our experience, those very high prices often flow over to other assets as well.
In credit markets, the compensation received for bearing credit risk for corporate debt in Australia is currently below 1% (RBA - Non-financial corporate BBB-rated bonds – Spread to swap – 5-year target tenor)6. In equity markets, dividend yields on global indices are below 1.7%; equity price to earnings multiples are elevated at 24 times current earnings and over 30 times on longer-term measures7.
In our view, credit and equities, on average, look expensive now on a valuation basis. Yields are lower and multiples are higher. The only area in which they are not expensive is when either are compared to bonds, as they are more expensive, or to a lesser degree against current fundamentals such as earnings or default rates, as they are currently strong. Either way, a traditional balanced portfolio is more likely to deliver low returns for some time based on current market yields and our own estimates.
In Australia and globally, the price environment in recent decades has been one of deflation, not inflation. However, now the Reserve Bank of Australia and other central banks have committed to getting the economy out of its current state. They’ve committed to building up inflation.8
Governments around the world are implementing an unprecedented amount of fiscal stimulus, at least in non-war times.9
Real bond yields are currently at all-time lows. Even if inflation only returns to target ranges and stays there, we expect that real rates should move back to positive territory to reflect the recovery in economies. At the very least that puts bond prices under pressure and increases the risk that higher yields flow into a repricing in other assets. A scenario where economies overheat and inflation actually requires suppression would be an even greater risk to asset prices.
How should an investor think about this? How do they find protection? How do they position their portfolios to perform and ride out the cycles?
In our opinion, following the same traditional strategy as before won’t earn the returns expected in the past.
To increase expected returns in a portfolio, an investor can take more risk but that comes at a price in terms of volatility.
One approach is to hold more exposure to higher yielding equities, but alleviate some of the extra risk through greater focus on managing the downside. This could involve capital guarantees or hedging techniques designed to limit how much an investor should be able to lose. For individuals, who have retirement in the forefront of their investment horizon, it could also mean spending less now, knowing that their future capital may not grow by as much as they had expected.
It’s also worth noting the role of fees in a low return environment. Passive investing has lower fees. In fact, in recent years it's been a race to the bottom in terms of fees charges for index fund providers.
Paying a reasonable amount in portfolio fees for any differentiated return sources, such as through active management, looks reasonable given the greater relative benefit from outperforming the market. At a time when the gap between valuations of growth stocks (that are expected to benefit more from high rates) relative to value stocks (that do not benefit as much) is again at close to the widest levels ever seen, that relative benefit also has relative opportunity.10
Investors have had a great ride of returns in the past few years. They’ve been able to hold a mix of basic assets and get decent returns. In fact, it’s been a Goldilocks environment for diversified portfolios. Just holding equities and bonds meant your portfolio would have done well in recent years, and the low bond yields have supported the equity market.
When equities have sold off in the past, it’s mostly been on the back of deflation fears. Conversely, that’s when bond markets have rallied. It wasn’t hard to grow your portfolio’s capital return. The market was doing it for you.
But times have changed. In our opinion, it may be time to do things a little bit differently.
1 Bloomberg. As at 30 June 2021.
2 Bloomberg, S&P 500 Index.
3 AMP Capital
5 Bloomberg. As at 23 August 2021.
6 Reserve Bank of Australia.
7 Citibank Global Market Intelligence As at 31 July 2021.
10 Bloomberg. Russell 1000 Value Index aggregate price-to-book ratio / Russell 1000 Growth Index Aggregate price to book ratio, Date range 31 March 1995- 23 August 2021.
Subscribe below to Market Watch to receive my latest articlesMatt Hopkins, Senior Portfolio Manager Multi-Asset Fund
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