Tuesday 05 July 2016 by Opinion

Ten year asset class returns – What does the “new normal” mean for investors?

Excessive leverage in banking and housing, and then by governments via quantitative easing, has led to a weakened global economy – with the years ahead forecasted to have weak returns and ongoing volatility

“May you live in interesting times”, Robert Kennedy, 1966

Misquoted as a Chinese curse, Kennedy’s prophesy is perfectly suited to investors 50 years later in 2016.  Excessive leverage first in banking and housing and then by governments via QE has led to a weakened global economy struggling against significant headwinds, including a political shift toward nationalism across the globe.  More specifically for investors, this has created very volatile returns in the past few years and the prospect of weak returns and ongoing volatility in years ahead.

Past 10 years’ returns

The chart below shows the average returns per year across a range of bonds, equities and property asset classes. 

Figure 1: Bonds and residential property dominate returns over the past 10 years
Total returns from superannuation investor perspective, net of all costs and inclusive of imputation credit benefits.

Source: S&P, Core data

The chart uses “total” return as it includes income such as dividends, rental income, and it includes the tax benefits of imputation credits for a superannuation investor.  Property returns are also net of stamp duty, renovation costs and property management costs.  That is, it is a fair, like for like comparison from the perspective of a superannuation investor (non super investors would have received lower returns from Australian equities and listed property but all other asset classes would be the same).

As shown in Figure 1, the lower volatility asset classes of bonds and residential property have also been the strongest returning investments, even after taking into account dividend imputation credits.

To adjust for the large differences in risk between the asset classes, we have diluted the riskier assets with a cash holding so that all the asset class returns represent the same risk.  For example, the Global Property returns in Figure 2 are the result of holding 42% in global property and 58% in cash, resulting in the same risk as Investment Grade Corporate Bonds.  The same is repeated for all the asset classes in Figure 2.

Figure 2: Risk adjusted returns
Past 10 years returns adjusted for risk by reducing all asset classes to the same level of risk as Investment Grade Corporate Bonds

Source: S&P, Core data, FIIG Securities

Most forecasters expect high yield bonds and residential property to maintain this leadership position for several years ahead, as shown in Figure 3 below.

Figure 3: Analysts’ average forecasted returns next 10 years
Total returns, including imputation benefits, all converted into AUD

Source: Blackrock, AMP Capital, Vanguard, Portfolio Solutions, Schroders and SSGA
Where available, ten year forecasts were used and 30 year forecasts were used as a cross check.  The AUD conversion used a 0.40%pa pickup for the higher yield expected in Australia over that timeframe.  

Key trends over the past 10 years and implications for the next 10:

  1. All asset classes have benefitted from yield compression: Bond returns include capital gains as yields have fallen; dividend yields and dividend payout ratios have pushed up share prices; and property returns have benefitted from falling rental yields. Yield compression is expected to continue as a long term trend.  This is the result of lower economic growth suppressing returns from growth assets and an aging population hunting for yield from all asset classes.  As we’ve seen in the past few years, this will put pressure on any asset offering regular income, keeping bond yields, credit spreads, dividend yields and rental yields lower for longer.
  2. US High Yield corporate bonds were the strongest performer and outperformance is expected to continue: This category includes all high yield rating levels, but interestingly the “BB” category returned 8.82%pa during this time and offered the lowest volatility too.  These returns don’t include any impact from currency, although over the past ten years currency hedging would have made little difference as the AUD/USD was $0.7465 ten years ago and around the same today.  As shown in the “Next 10 years’ returns” section above, High Yield is also amongst the highest performers expected in the years ahead.
  3. Inflation linked bonds were a surprisingly strong performer in the past: It should be noted that the data in Figure 1 is for government bonds with a CPI linked return, so it excludes the additional yield available from assets such as Sydney Airport.  Inflation linked bonds have benefited from the lower real interest rates and the lower inflation outlook that has developed over the past decade, and so it is hard to build an argument for government  inflation linked bonds performing at this level over the next 10 years.  Infrastructure inflation linked bonds may be able to achieve stronger returns if credit spreads compress. The forecasts by Blackrock included in Figure 3 are for global infrastructure bonds as a whole, not just inflation linked so they might not be a like for like comparison.  They do however show a ranking of returns more in line with where one would expect them to be given the lower risk.
  4. Residential property has been hard to beat in the past ten years: While like all asset classes, there has been a boost to returns from falling rental yields, a shortfall in supply also strengthened property prices along much of the east coast of Australia.  Forecasting residential property returns has been notoriously challenging, but using the forecasts of the best analysts over the past 10 years, returns in the future are expected to hold around the 4 5%pa level in the major capital cities, again based on limited land availability and yield compression.
  5. Investment grade corporate bonds have performed ahead of equities in Australia and globally: Investors taking a conservative stance over the past ten years have been well rewarded.  Not only have they outperformed equities, they have experienced much lower volatility.  Looking ahead, it is difficult to forecast returns from lower risk bonds outperforming equities.  Blackrock’s forecasts for the next five years for example are for US equities to return 4.3%pa and investment grade corporate bonds around 1.8%pa (with 70% less volatility).  Interestingly, however, they are forecasting US high yield corporate bonds to return more than equities at 4.8%pa, but with around 40% less volatility.
Both the rear vision and the windscreen are in a rare agreement: in a continuing period of low growth combined with heightened economic and social volatility, fixed income investments will need to form a greater proportion of a well balanced portfolio, particular for a conservative, income seeking investor.  High yield and investment grade corporate bonds, weighted according to an individual’s risk preference, infrastructure bonds, property assets (with limited gearing) and low risk, low dividend payout ratio equities will most likely produce the best risk adjusted returns in the coming years.