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.


Source: Thomson Reuters, Global Financial Data, AMP Capital

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:



# Current dividend yield for shares, distribution/net rental yields for property and 5 year bond yield for bonds. ^ Includes forward points. * With franking credits added in. Source: AMP Capital

Thematics

Several themes have been reflected in these projections:

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.

Implications for investors

There are several implications for investors:



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This video must be taken in its entirety and any given chapter viewed in isolation does not represent the entire message.

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

 

1For 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.

Important note: 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) 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.