Trends point to a low return world

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Added on 28 July 2010 @ 2:38 PM

TODAY’S MAJOR TRENDS ALL POINT TO A LOW-RETURN WORLD

Today’s major global economic and financial trends all point to significantly lower returns from most asset classes over the next decade, making it more important than ever for investors to ensure they save more and include as much equity as possible in their long-term portfolios, according to Peter Brooke, head of Macro Strategy Investments at Old Mutual Investment Group (SA) (OMIGSA).

“What’s worrying is that most people – including investment professionals – don’t seem to realise this,” says Brooke. “ OMIGSA recently asked 826 professional advisers and brokers across South Africa what they believed was the appropriate equity exposure needed to achieve a return of inflation (CPI) +7% for their clients, and only 35% were correct in saying over 80% of a portfolio. Some 65% of respondents opted for less than 80%, which is unrealistically optimistic. What this shows us is that people aiming for high returns are investing too conservatively, and unless they adapt their savings and investment behaviour accordingly, they are going to be disappointed.”

Brooke has identified five key themes likely to dominate global investing for some years to come, which are: Big Government; Cash is Trash; Emerging Markets; A Low-Return World; and The Quest for Yield. All of these have negative implications for most asset class returns, but equities - especially emerging market equities - are most likely to produce the strongest real returns over the next five years. High dividend-yielding equities are a particularly smart option, he believes, also offering protection against inflation.

Big Government and Cash is Trash

Looking at the themes of “Big Government” and “Cash is Trash”, Brooke points out that in the aftermath of the global financial crisis, the unprecedented mountains of government debt built up in many developed nations will weigh heavily on economic growth for years to come. Cutbacks in government spending and slow growth will keep inflation, and therefore interest rates, low in many European countries, the US and UK, in turn pushing down yields on cash and bonds.

“One consequence of this for South African investors is that it makes offshore cash and bond investments unattractive – we are forecasting 0% p.a. real returns from offshore cash and 1% p.a. real returns from offshore bonds for the next five years,” notes Brooke. “If you need cash in your portfolio, it should be invested in the local market, where at least you can get a real yield of around 2.5% p.a..”

Emerging Markets

With interest rates remaining historically low in many developed countries, and the highest economic growth coming from emerging markets, large sums of money will necessarily flow into emerging markets in the next few years, making them the most obvious place for asset bubbles to emerge, notes Brooke. “While much has been written on the growth and investment potentials of Brazil, India and China, I believe it is additionally the next tier of countries – where middle-class populations are also large and growing rapidly like Indonesia, Iran, Turkey, Egypt and Nigeria – where a lot of the action will be. The latter two African heavyweights point to the increasing popularity of Africa as a future investment destination.”

The key question is whether emerging market equities are already highly priced, and have investors therefore already missed the boat when it comes to investing in these markets? The good news, says Brooke, is that there are still lots of opportunities for strong returns there. “Although there has been a big run in emerging markets already, having outperformed very strongly, it’s important to realise that this has come from a very low base following the crash in 1998. So when we look at current valuations we find that emerging markets are still trading at a discount to developed markets, even when you consider the risk involved. This is why I have been increasing the emerging market equity exposure in the funds I manage where possible, and see this asset class as a ‘buy’.”

A Low-Return World

Brooke advises investors to prepare themselves for lower returns from most asset classes going forward, compared to those they’ve experienced in the past decade. “Looking back, the decade 2000-2009 was an exceptional one for South African investors, who enjoyed extraordinary above-inflation returns of 17.7% p.a. from listed property, 9.8% p.a. from SA equities, and 6.1% p.a. from local bonds. Diversified portfolios, using the Old Mutual Profile Balanced Fund as an example, returned a very healthy real return of 8.3% p.a..”

Given the global outlook, there’s very little chance of seeing these kinds of returns in the new decade. “Cash and bonds will continue to be depressed by high debt levels and low interest rates, with only low real returns of 2.5%-3.0% p.a. from these asset classes likely in the local market. This leaves property and equities to offer the best real returns, but even these asset classes will be hampered by the generally lower economic growth expected in developed countries. Profits will also be put under pressure from the theme of big government. We are estimating real returns of 6.0% p.a. and 6.5% p.a. from SA property and equity, respectively, over the next five years, and 7.0% p.a. from offshore equity. And it’s important to remember that these come with higher risk. So for fund managers trying to construct a diversified portfolio with appropriate risk for investors, the challenge will be to seize the best value opportunities as they arise, requiring even more active and savvy management. In a low-return world investors have got to be very hungry about chasing any extra returns.”

The Quest for Yield

A key implication of a low-return world is that investors will necessarily be forced to look harder and further - beyond cash and bonds and their own national borders - to achieve returns that significantly outpace inflation. Investors from developed countries, for example, are already looking to developing country assets like South African government bonds for their relatively high yield compared to US Treasuries, despite the higher political risk, says Brooke.

For SA investors looking for yield, Brooke is convinced that the most reliable source going forward will come from dividends. “Dividends will be where it’s at,” he says. “If and when inflation becomes a more serious threat, history has shown that it’s much better to be in equity than in bonds, and dividend payouts provide more reliable protection over time than cash.

“Furthermore, with lower capital growth expected from equities, dividends will play a more important role in total equity returns going forward, and in the local market, high dividend-yielding shares have typically outperformed low-dividend shares in times of falling or low interest rates. So investors who are comfortable with some equity risk should consider including funds focusing on high dividend-yielding shares in their portfolios.”

Fairbairn Capital | Old Mutual

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