Callum Thomas
Investment Strategist, Multi-Asset Group

Low inflation, low starting point yields and constrained global growth means investors will need to adjust to single digit annual returns for the medium term. In this article, we provide our investment outlook for the medium term by drawing on our capital market assumptions across growth and defensive assets.

The starting point for returns today is less favourable than when the last secular bull market in bonds and shares started in 1982, due to much lower yields, lower potential growth, and higher valuations. Our projection* for returns over the medium term is for around 7% p.a. from a diversified balanced-growth mix of assets.

Performance expectations

Regionally, global equities most closely affected by unconventional policy easing appear most likely to outperform, notably in Japanese, Chinese, and European equities, where the central banks are still aggressively easing monetary policy, valuation is supportive and economic tailwinds such as cheaper energy prices are in play; these are also regions that suffer from structural challenges.

The widening of credit spreads over the past year has created sizeable risk premia that offer potentially attractive, expected medium-term returns. Selectivity at a regional, sectoral and issuer level is key, as the default cycle is turning and continued US Federal Reserve tightening would amplify corporate event risk in coming years. We expect the best performance from lower rated credits and convertibles.

Commercial property and infrastructure are likely to continue benefiting from the ongoing search for yield over the medium-term, as bond yields remain around historical lows.

Figure 1: Medium-term (5-7 years) return forecasts

Past performance is not a reliable indicator of future performance

# Current dividend yield for shares, distribution/net rental yields for property and five-year bond yields for bonds.*

The Australian dividend yield is net/grossed-up for franking credits

^ Columns may not add precisely to the total due to rounding

Source: AMP Capital

Dominant themes constraining the growth outlook

Several themes are considered in our projections for capital growth: low inflation; aging populations; slower household debt accumulation; the downtrend in commodity prices; ongoing technological innovation and automation; reinvigorated advanced countries versus struggling emerging markets; increased geopolitical tensions in a multi-polar world; increased regulation and scepticism of free markets. Most of these are likely to have the effect of constraining nominal economic growth and hence total returns. 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 however, not so for Australia due to lowered real economic growth assumptions.

US equities – reasonable growth over time

The US is showing signs of continuing sluggish but positive growth, with some weak spots around energy-related investment and manufacturing. As shown in the graph below, our total return forecast of 8.1% over the medium term (at the time of writing) reflects a dividend yield of 2.1%, hedging premium (to AUD) of 1.7% and capital growth of 4.3% which comes from expected trend gross domestic product (GDP) growth of 2.5% and trend inflation of 1.75%. So while there may be some short-term concerns about the outlook, our view is that trend nominal GDP growth of around 4.25% should translate into reasonable capital growth for equities over time. Of course, the starting valuation will play a big role in determining realised returns.

Figure 2: US equities – actual and projected 10-year returns

Past performance is not a reliable indicator of future performance

Source: Thomson Reuters, Global Financial Data, AMP Capital

The importance of diversification and active asset allocation

Global growth remains fragile and constrained; this is continuing to drive bouts of volatility in investment markets. In the medium term, our valuation indicators remain supportive for shares, particularly following the correction and further turndown in bond yields. The uneven and volatile return environment provides a reminder of the benefits of diversification. Using a dynamic approach to asset allocation makes sense as a way to enhance returns when the return potential from the underlying markets is constrained.

Low medium-term returns generating positive outcomes

While it’s important to come from a sound starting point, the current environment reminds us of the importance of active asset allocation. In our dynamic asset allocation process, cyclical quantitative scores such as valuation, liquidity and sentiment are used to guide the medium-term returns for dynamic portfolio construction.

For example: the market correction at the start of 2016 led to an improvement in valuation and sentiment scores for equities; we upgraded our return assumptions in the DAA process to reflect the changing market conditions.

If a flexible and active approach to portfolio management is practiced through the cycle, low medium-term return expectations do not necessarily doom investors to low realised returns.

*Ignores any contribution or detraction from active asset allocation, stock selection and any taxes and fees.

Callum Thomas, Investment Strategist, Multi-Asset Group

Callum Thomas, Investment Strategist at AMP Capital is responsible for researching a range of asset classes and global macroeconomic themes to aid in formulating investment strategies across the Multi-Asset Group.
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.