Adjusting to a low-yield world: don’t expect double-digit growth
The combination of low inflation, low starting point yields and constrained global growth means investors will need to adjust to single digit annual returns over a medium-term horizon.
In this article, we present our medium-term investment outlook, drawing on our capital market assumptions across both growth and defensive assets. Building up from observable market yields, our total return estimates bring in our view of longer term potential growth and inflation. With a 5-7 year timeframe our preference is to look through the cycle and avoid overly precise forecasts and bring in key factors such as demographics and productivity growth.
A less favourable starting point returns
The starting point for returns today is far less favourable than when the last secular bull market in bonds and shares started in 1982, due to much lower yields. Our medium-term return projections imply a 7.4% p.a. return from a theoretical diversified growth mix of assets (with franking credits), compared to an average 14% p.a. return by Australian balanced growth super funds over the 1982-2007 period (pre-fees and taxes).
Regionally, global equities most closely affected by unconventional policy easing appear most likely to outperform, notably in Japanese and European equities, where the central banks are still easing policy, valuation is supportive, and economic tailwinds such as cheaper energy prices are in play.
The widening of credit spreads over the past year has created significant risk premia that appear to overestimate aggregate corporate default risks and thus 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.
Diagram 1: Medium-term (5-7 years) return forecasts
# 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
Megatrends constraining the growth outlook
Several themes are considered in our projections for capital growth including:
- 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. 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; it’s a headwind for Australia (we have lowered our real economic growth assumptions).
Diversification and active asset allocation are critical
Global growth remains fragile and constrained and 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.
Medium-term returns in action – how we use them
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, 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 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.
About the author
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.