Introduction

Way back in the early 1980s it was pretty obvious that the medium term (five year) return potential from investing was pretty solid. The RBA's "cash rate" was averaging around 14%, 3 year bank term deposit rates were around 12%, 10 year bond yields were around 13.5%, property yields were running around 8-9% (both commercial and residential) and dividend yields on shares were around 6.5% in Australia and 5% globally. Such yields meant that investments were already providing very high cash income and for growth assets like property or shares only modest capital growth was necessary to generate pretty good returns. Well at least the return potential was obviously attractive in nominal terms as back then inflation was running around 9% and the big fear was it would break higher. As it turns out most assets had spectacular returns in the 1980s and 1990s. This can be seen in returns for superannuation funds which averaged 14.1% in nominal terms and 9.4% in real terms between 1982 and 1999 (after taxes and fees).

Source: Mercer Investment Consulting, Morningstar, AMP Capital

Now it’s not quite so clear as yields have fallen across the board. The RBA cash rate is just 2%, 3 year bank term deposit rates are just 2.7%, 10 year bond yields are just 2.9%, gross residential property yields are around 3% and while dividend yields are still around 6% for Australian shares (with franking credits) they are around 2.5% for global shares. While the recovery from the GFC and the Eurozone debt crisis and the fall in yields (which goes hand in hand with capital growth for bonds and growth assets) has seen solid double digit returns from a diversified mix of assets over the last few years, it would be dangerous to assume that we have now returned to a world where double digit annual returns are the sustainable norm

This note takes a look at the medium term return potential from a range of assets and what it means for investors.

Don't look back – what drives potential returns?

We all know the disclaimer that past returns are not necessarily a guide to future returns. This applies just as much to investment markets as it does to managed funds. Simply taking a long term average of historical returns may be a guide to future returns, but it can be very misleading for the medium term as it ignores the significant impact of starting point valuations. Eg, if current yields – say bond yields and dividend yields – are lower than normal then this will potentially constrain returns relative to what has been seen over the long term.

Investment returns have two components: capital growth and yield (or income flow). The yield is the most secure component and generally speaking the level it starts at when you undertake the investment is key, put simply the higher the better. So our approach to get a handle on medium term return potential is to start with current yields for each asset and apply simple and consistent assumptions regarding capital growth. We also prefer to avoid a reliance on forecasting and to keep the analysis as simple as possible. Complicated adjustments can just lead to compounding forecasting errors.

Source: Thomson Reuters, Global Financial Data, AMP Capital

Projections for medium term returns

This approach 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:

The return implied for a diversified growth mix of assets has now fallen to 7.3% pa and is shown in the final row.

Projected medium term returns, %pa, pre fees & taxes

  Current Yield # + Growth    = Return  
World equities 4.2 ^ 4.2 8.4
Asia ex Japan equities 2.6 ^ 7.0 9.6
Emerging equities 0.8 ^ 6.5 7.3
Australian equities 4.5 (5.9*) 4.2 8.7 (10.1*)
Unlisted commercial property 6.0 2.0 8.0
Australian REITS 4.4 2.5 6.9
Global REITS 4.8 ^ 2.0 6.8
Unlisted infrastructure 6.0 3.1 9.1
Australian government bonds 2.5 0.0 2.5
Australian corporate debt 3.6 0.0 3.6
Australian cash 3.2 0.0 3.2
Diversified Groth mix*     7.3
# 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

Megatrends influencing the growth outlook

Several themes are allowed for in our projections for capital growth: low inflation; aging populations; slower household debt accumulation; a continued downtrend in commodity prices; ongoing technological innovation and automation; reinvigorated advanced countries versus emerging markets; increased geopolitical tensions in a multi-polar world; increased regulation and scepticism of free markets. Most of these will likely have the effect of constraining nominal economic growth and hence total returns. But not necessarily. Increasing automation is positive for profits and the downtrend in commodity prices is positive for commodity users such as the US, Europe, Japan and Asia but not so good for Australia (where we have lowered our real economic growth assumptions).

Observations

Several observations flow from these projections.

Source: AMP Capital

Implications for investors

There are several implications for investors:

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital's diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.