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What return can you expect in this market?

Photo of Shane Oliver By Shane Oliver

min read

Double-digit gains are a thing of the past for diversified growth portfolios, but there are still ways to prosper.

Way back in the early 1980s, it was obvious the medium-term (five-year) return potential from investing was solid.

The Reserve Bank’s cash rate was averaging around 14 per cent, three-year bank term deposits about 12 per cent, 10-year bond yields about 13.5 per cent, property yields (commercial and residential) about 8 to 9 per cent, and dividend yields on shares were around 6.5 per cent in Australia and 5 per cent globally.

Such yields meant that investments were already providing very high cash income and for growth assets such as property or shares, only modest capital growth was necessary to generate good returns.

Well, at least the return potential was obviously attractive in nominal terms, as back then inflation was running around 9 per cent and the big fear was it would break higher.

As it turned out, most assets had spectacular returns in the 1980s and 1990s. This can be seen in superannuation funds, which averaged 14.1 per cent in nominal terms and 9.4 per cent in real terms between 1982 and 1999, after taxes and fees.


 

Source: Mercer Investment Consulting, Morningstar, AMP Capital

Yields have fallen across the board. The RBA cash rate is just 2 per cent, three-year bank term deposits 2.7 per cent, 10-year bond yields 2.9 per cent, gross residential property yields about 3 per cent, and while dividend yields are still around 6 per cent for Australian shares (with franking credits) they are around 2.5 per cent for global shares.

Although 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 past few years, it would be dangerous to assume we have now returned to a world where double-digit annual returns are the sustainable norm.

Don't look back – what drives potential returns?
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.

  • For equities, a simple model of current dividend yields plus trend nominal GDP growth (as a proxy for earnings and capital growth) does a good job of predicting medium-term returns. This approach allows for current valuations (via the yield) but avoids getting too complicated. The next chart shows this approach applied to US equities, where it can be seen to broadly track big secular swings in returns.
  • For property, we use current rental yields and likely trend inflation as a proxy for rental and capital growth.
  • For unlisted infrastructure, we use current average yields and capital growth just ahead of inflation.
  • For bonds, the best predictor of future medium-term returns is the current five-year bond yield. In other words, capital growth is zero because if a five-year bond is held to maturity, its initial yield will be its return.

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:

  • We assume central banks meet their inflation targets over time: 2.5 per cent in Australia and 2 per cent in the US.
  • We allow for forward points in the return projections for global assets based around current market pricing – which adds 1.8 per cent to the return from world equities.
  • The Australian cash rate is assumed to average 3.25 per cent over the next five years. Cash is one asset where the current yield is of no value in assessing the asset’s medium-term return potential because the maturity is so short. So we assume a medium-term average.

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

  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 Growth mix* - - 7.3

# Current dividend yield for shares, distribution/net rental yields for property and five-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; ageing populations; slower household debt accumulation; 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 possibly 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.

  • The medium-term return potential remains low. In fact, the rally in most assets of the past few years has seen it steadily decline. The next chart shows projected medium-term returns using this approach for a diversified growth mix of assets since 2008, over which time there has been a decline from 9.2 per cent per annum to 7.3 per cent per annum. At the GFC low point, this approach was signalling an attractive 10.3 per cent per annum return.

Source: AMP Capital

  • The starting point for returns today is far less favourable than when the last secular bull market in bonds and shares started in 1982, because of much lower yields. Our medium-term return projections implying a 7.3 per cent per annum return now from a diversified mix of assets, compare to an average 14 per cent per annum return by Australian balanced growth super funds between 1982 and 2007, before fees and taxes.
  • Government bonds offer very low return potential. The combination of low yields and the risk they will rise, causing capital loss, implies low medium-term return potential.
  • Unlisted commercial property and infrastructure continue to come out well, reflecting their relatively high yields.
  • Australian shares stack up well on the basis of yield, but it is hard to beat Asian shares for growth potential, and falling commodity prices are a headwind for Australian shares.
     

There are several implications for investors:

  • First, have reasonable return expectations. The GFC is way behind us but the combination of low inflation, low starting-point yields and constrained GDP growth indicate it is not reasonable to expect year after year of double-digit returns. In fact, the decline in the rolling 10-year moving average of superannuation fund returns (first chart) indicates we have been in a lower return world for some time now.
  • Second, 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. This is likely to be enhanced by continued bouts of market volatility (Editor’s note: dynamic asset allocation involves tactical portfolio tilts to take advantage of opportunities in asset classes).
  • Third, there is still a case for a bias towards Australian shares for yield-focused investors. But it makes sense to have a bit more offshore, including in traditional global shares, which are looking a bit healthier after a long tough patch, and in Asian (ex-Japan) shares.
  • Fourth, focus on assets providing decent sustainable income. This provides confidence regarding returns, e.g. commercial property and infrastructure.

 

About the author

Shane Oliver is Head of Investment Strategy and Chief Economist at AMP.

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