THEME 02 PERSPECTIVES DIVERSIFIED RETURNS ACTUAL 14.0% 1982-2007 ADJUSTING TO A LOW AUSTRALIAN EQUITIES YIELD 8.9% GLOBAL EQUITIES WORLD GLOBAL LISTED 8.5% INFRASTRUCTURE 8.1% GLOBAL REITs RETURNS 7.1% DIVERSIFIED 7.4% AUSTRALIAN GOVERNMENT BONDS 2.3% MEDIUM-TERM RETURN OUTLOOK: REFLECTS SUBDUED GROWTH AND LOW INFLATION 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. This article presents our medium-term investment outlook, drawing on our capital market assumptions across both growth and defensive assets. KEY POINTS > > We avoid complicated adjustments to forecasts as these can lead to compounding errors > > Investors will need to adjust to a low-yield world: don t expect double-digit growth > > There are some megatrends constraining the growth outlook > > We expect reasonable capital growth for US equities over time > > Low medium term return expectations do not necessarily doom investors to low realised returns CONTRIBUTING AUTHOR INSIGHTS.IDEAS.RESULTS. CALLUM THOMAS Investment Strategist, Multi-Asset Group PERSPECTIVES insights.ideas.results.
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. This article presents 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 time frame our preference is to look through the cycle and avoid overly precise forecasts and bring in key factors such as demographics and productivity growth. As such, when it comes to this sort of forecasting our preference is to be 'approximately right' rather than 'precisely wrong'. METHODOLOGY FOR PROJECTING MEDIUM TERM RETURNS The Multi-Asset Group s mediumterm return outlook is based on the current yields for each asset and a set of consistent assumptions regarding capital growth. We believe that complicated adjustments can lead to compounding errors so we avoid a reliance on forecasting. > > EQUITIES: we model current dividend yields and trend/ potential nominal GDP growth (as a proxy for earnings and capital growth) to predict medium term returns. This approach allows for current valuations via current yields without getting too complicated e.g. by dictating a level that valuations should mean-revert to. > > PROPERTY: we apply current rental yields and trend inflation as a proxy for rental and capital growth. > > UNLISTED INFRASTRUCTURE: we use current average yields and capital growth pre-inflation. > > BONDS: the best predictor of future medium term returns is the current five year bond yield. Note that: (1) We assume central banks meet their inflation targets over time, for example 2.5% in Australia and 2% in the US, albeit we may downgrade (or upgrade) this where appropriate; (2) We allow for forward points in the return projections for global assets based around current market pricing which adds 1.8% to the return from global equities; (3) The Australian cash rate is assumed to average 3.25% over the next five years. PERSPECTIVES insights.ideas.outcomes. 2
ADJUSTING TO A LOW-YIELD WORLD: DON T EXPECT DOUBLE-DIGIT GROWTH 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. The starting point for returns today is far less favourable. 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 CURRENT YIELD # + HEDGE POINTS + GROWTH = RETURN^ US equities 2.3 1.5 4.3 8.1 Asia ex Japan equities 3.2 0.4 6.8 10.4 Emerging equities 3.4-1.6 6.3 8.0 World equities, local currencies 2.9 1.8 3.9 8.5 Australian equities* 5.6/7.2 0.0 3.3 8.9/10.5 Unlisted commercial property 6.0 0.0 2.0 8.0 Australian REITs 5.1 0.0 2.3 7.3 Global REITs 3.9 1.4 1.8 7.1 Unlisted infrastructure 5.0 0.7 3.1 8.8 Global listed infrastructure 3.7 1.6 2.8 8.1 Australian Government bonds 2.3 0.0 0.0 2.3 Australian corporate debt 4.1 0.0 0.0 4.1 Australian cash 2.7 0.0 0.0 2.7 Diversified growth mix 7.4 # 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 CONSTRAINING THE GROWTH OUTLOOK Several themes are considered 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. 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). PERSPECTIVES insights.ideas.results. 3
Figure 2: US equities actual and projected 10-year returns (%) p.a. 25 20 15 10 5 0-5 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 Actual return = 10-year trailing equity return Projected return = dividend yield + growth, advanced-10 years Source: Thomson Reuters, Global Financial Data, AMP Capital SPOTLIGHT ON US EQUITIES: ON THE RISE OR WEAKNESS AHEAD? The US is showing signs of continuing sluggish but positive growth, with some weak spots around energy-related investment and manufacturing. In figure 2, our total return forecast of 8.1% over the medium term at the time of writing, reflects a dividend yield of 2.3%, hedging premium (to AUD) of 1.5%, and capital growth of 4.3% which comes from expected trend 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 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. 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. IN SUMMARY > > Over the medium-term, nominal economic growth will be constrained and investors will need to adjust to single-digit annual returns. > > Our projections imply a 7.4% p.a. return from a theoretical diversified growth mix of assets. > > Japanese and European equities where the central banks are still easing policy are most likely to outperform. > > The default cycle is turning and continued US Federal Reserve tightening will amplify corporate event risk in coming years; selectively at a regional, sectoral and issuer level is key. > > Commercial property and infrastructure are likely to continue benefiting from the ongoing search for yield. > > The US is showing signs of continuing sluggish but positive growth, with some weak spots around energy-related investment and manufacturing. > > The current environment reminds us of the importance of active asset allocation and diversification. PERSPECTIVES insights.ideas.results. 4
PERSPECTIVES INSIGHTS.IDEAS.RESULTS. Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty 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 document 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 document, and seek professional advice, having regard to the investor s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital. Copyright 2016 AMP Capital Investors Limited. All rights reserved. PERSPECTIVES insights.ideas.outcomes. 5