Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 174

Achieving real returns in a low growth world

This article looks at how investors can realistically assess current market challenges and what they can do to achieve meaningful returns with reasonable risk levels.

Overview

The idea that we have entered a ‘low-return’ world now seems to be a consensus. The arguments are based on a combination of fundamental macro factors (a low growth world) and extended structural valuations in both equity and debt markets that suggest both bond and equity market returns face significant headwinds.

Achieving solid real returns consistently in this environment will be arduous. That said, at Schroders we believe beating inflation with a 5% excess real return over the medium term is still an appropriate and achievable objective. This view is based on several key ideas:

  • the structural valuation challenges in equity markets are not uniform nor are they extreme (either in absolute terms or by historic standards).
  • markets rarely move in straight lines, especially when conditions are challenging; it is reasonable to expect considerable cyclical volatility.
  • flexible asset allocation ranges and active management are essential.
  • approaches that embed the structural risk of either equities or bonds will likely struggle to deliver consistently. This includes balanced funds, with fixed strategic asset allocations or embedded duration risk (leverage) in the strategy, as the risk around bonds becomes increasingly asymmetric.

A low-return world

The concept of a ‘low-return’ environment is underpinned by a structurally weak global economy with consequences for growth rates, inflation, interest rates, bond yields, and earnings. The bleak growth outlook is due to a number of factors such as:

  • high debt levels and pressure to de-lever across the broader global economy
  • demographic influences (especially in China, Japan and Europe)
  • moderating productivity growth and the potential ‘normalisation’ of a structurally high US profit share
  • in Australia’s case, the additional unwinding of the China/commodity induced terms of trade boom, placing significant structural pressure on national income.

Compounding these factors are doubts about policy makers’ ability to effectively manage pressure from a number of areas including:

  • the extent to which monetary policy options have already been largely (arguably) exhausted (Europe, US and Japan)
  • Chinese debt and overcapacity against the backdrop of an economy undergoing a structural transformation
  • fiscal and structural policy that has effectively been side-lined by high global debt levels (both public and private sector) and the absence of clear political mandates
  • rising global income and wealth inequality and associated rises in social and political instability.

Valuations matter more than global growth

The correlation between economic factors and market performance is often over-emphasised. Strong economic growth does not necessarily mean strong market performance, whereas the link between valuations and future returns is significant – particularly over the medium to longer term. This is true for both equity and bond markets.

While there is no unique and absolute valuation metric for equities, research shows a strong relationship between longer run, cycle adjusted price-to-earnings (CAPE) multiples and subsequent 10-year returns for US equities (see graph below).

US CAPE Ratio and 10 year Real Returns for US equities since 1900

Source: GFD, Yale, Schroders. The Shiller PE or Cyclically Adjusted PEs are calculated as price divided by 10 year trailing earnings, adjusted for inflation.

There are two main points to highlight:

  • high CAPE ratios have consistently been followed by structurally low returns. The current CAPE ratio of around 23x, while high in an historic context, is well below the 45x level that prevailed at the end of the tech boom of the 1990s, which was subsequently followed by a decade of negative real returns
  • while current structural valuations in the key US equity market are extended and consistent with longer-run returns below long-run averages, there is not the same downward pressure on returns that prevailed at past extremes (like the 1970s or 1980s).

This relationship also broadly holds for other markets, but structural valuations are moderately extended in the US, consistent with relatively low (albeit not extremely low) prospective returns. However, in the UK, Europe and Australia, structural valuations are reasonable (around long-run averages) and therefore consistent with longer run rates of return.

While it will be challenging in some areas (especially the US), we expect a positive longer run trend (unlike in Japan over the past two-and-a-half decades or in the US through the 2000s.)

The problem with bonds

Bond markets are potentially more difficult, with record low bond yields implying low/negative returns from sovereign bonds and for assets priced directly from bond yields. This issue has become particularly more acute, with negative yields prevailing across large swathes of the global sovereign bond market (especially Europe and Japan), with extremely low yields in the residual, as shown in the figure below.

Negative yields don’t auger well for future bond returns

Negative yields don’t auger well for future bond returns

Source: Bloomberg, June 2016

While bond returns will vary in the short run as expectations about the future course of interest rates ebb and flow, over the longer term we know with some certainty (in nominal terms anyway) what returns will be. Holding negative yielding bonds to maturity will generate negative returns.

Typically, bonds have been held in portfolios to help diversify equity risk. Structurally low yields limit the ability of bonds to perform this function. The exception is in the context of deflation where the risk to nominal bond yields would still be to the downside. That said, it does have implications for portfolio construction.

Long-run returns

The issues outlined above are factored into our long-run return forecasts for key asset classes. These are primarily derived from a combination of the broader macro-economic backdrop and an adjustment for long-run valuations. While we expect modest long-term returns from equities, they should nonetheless still be positive in real terms, as shown below.

schroders-pt1-figure-3

In summary, while the structural valuation backdrop is challenging, it is not uniform, nor in the case of equities as extreme as it has been historically. For example, while US equities look structurally the most extended of the major equity markets they are far from the extremes that prevailed at the end of the 1990s tech boom. Australian equities, on the other hand, having devalued against the collapse in commodity prices, look like reasonable long-term value. The situation in bond markets is more problematic given prevailing negative nominal and real yields.

 

Simon Doyle is Head of Fixed Income & Multi-Asset at Schroder Investment Management Australia. Opinions, estimates and projections in this article constitute the current judgement of the author. They do not necessarily reflect the opinions of any member of the Schroders Group. This document should not be relied on as containing any investment, accounting, legal or tax advice.

 

RELATED ARTICLES

How inflation impacts different types of investments

Achieving real returns in a low-growth world (part 2)

Value of tax-aware investment management

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Retirement

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Property

Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.

Property

Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.

Shares

10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.