The day-to-day noise surrounding investment markets often makes it hard for investors to see the wood for the trees. As such, it is useful to be mindful of longer-term themes that will impact investment returns over the next 5 years or so.
This note brings together trends I have covered in previous editions and updates a similar analysis from two years ago.[1]
1. Low and relatively stable inflation
The secular trend in inflation has been a key driver of investment returns historically. Falling inflation through the 1980s and 1990s led to a sharp fall in bond yields and a sharp rise in price earnings multiples or PEs (ie, share prices rose faster than earnings), which generated great capital gains for both bond and share investors.
Source: Global Financial Data, RBA, AMP Capital Investors
This adjustment, and the associated one-off boost to financial asset returns it provided, is now well behind us and we are now likely to remain in a world of low inflation. In the 2004 edition of this note I thought central banks were taking a risk with inflation and that this would lead to a gradual rise. However, I would argue this is now largely over and central banks have reaffirmed their commitment to keeping inflation low. What’s more, global competition and technological innovation should make keeping inflation low easier, despite rising raw material costs. Still, the boost to investment returns from falling inflation is long gone.
Implications – expect sustainable returns from government bonds of around running yield (5.7% or less) and share returns to be constrained, as a big surge in PE ratios is unlikely.
2. Slower profit growth as the profit share stabilises
Strong productivity growth and reduced worker bargaining power has boosted profits at a phenomenal rate over the last few years. As a result, the profit share of GDP is historically high & the wages share of GDP is relatively low.
Source: Thomson Financial, AMP Capital Investors
History suggests profits won’t continue to surge relative to GDP. Continued low unemployment and slower labour force growth (as populations age) suggest upside risk for wages growth. Against this though, global labour market conditions remain very competitive.So, notwithstanding cyclical variations, it’s perhaps best to assume profit shares will now start to track sideways.
Implications – corporate profit growth is likely to be around nominal GDP growth on a sustained basis. In the absence of rising PEs, sustainable capital gains on shares are unlikely to exceed nominal GDP growth.
3. China, India and the Asian ascendancy
The ascendance of China, India and the rest of Asia is set to continue with trend growth rates more than double those likely in the developed world. This strong growth along with sound macro economic management compared to the 1990s, reduced debt levels, undervalued currencies and relatively attractive valuations suggests non-Japan Asian equity markets will continue to outperform developed country share markets on a 5-10 year view.
Implications – favour non-Japan Asian shares over mainstream equity markets (allowing of course for risk).
4. Strong industrial commodity prices
After a 25-year bear market industrial commoditieshave entered a secular bull market driven by strong structural demand on the back of industrialisation in Asia and other emerging markets, all at a time of still constrained supply. Notwithstanding cyclical fluctuations the longer-term trend in commodity prices is likely to remain strong.
Implications – positive for resources stocks and the Australian economy and provides support for the $A.
5. High and rising oil prices
Rapid industrialisation in China, India and emerging markets generally will lead to solid long-term growth in the demand for oil. Supply is struggling to keep up and this is likely to remain the case over the medium-term. The outcome is likely to be that oil prices remain relatively high until the necessary increase in supply and adjustment in demand is forthcoming.
Implications – positive for fuel (including alternative fuel) producers and for companies that switch to alternatives or meet consumer demand for more fuel-efficient cars; negative for energy importing countries and industries relying heavily on oil and where demand is elastic.
6. Globalisation and offshoring
There is nothing new in globalisation, but the reality is that it is intensifying, as cheap workers in China and India join the world trading system. Falling communication costs are seeing this rapidly spread to the services sector with functions being shifted to cheaper but highly educated labour forces in developing countries. Given the wage advantages this likely has a lot further to go.
Implications – this will benefit multinationals able to shift functions across boundaries but will continue to make life difficult for high cost local producers.
7. Aging populations and slowing population growth
It is well known that populations in Australia and other developed countries are ageing and population growth will slow. This is clearly worse in some countries, eg, Japan where the population is already falling, than others. Over time this will lower potential growth rates in many countries.
Implications – bad news for suburban houses over inner city housing and coastal resorts; positive for shares exposed to health care, tourism and leisure; retiring baby boomers could become a negative for shares generally in 5-10 years time (although this is debateable); more negative for Japanese shares than US & Australian shares.
8. The IT revolution
Technological innovation is continuing to drive a reduction in the cost of access to information technology (IT) and a continuing expansion in applications and functionality, from cheaper consumer products such as flat screen TVs to productivity enhancing business applications. As such, the IT revolution is continuing to transform the way we live and do business.
Implications – should be a positive for those IT stocks which have a clear and compelling competitive advantage on a long-term basis. Should also be positive for economic growth (via productivity growth) partly offsetting the negative impact flowing from slowing labour force growth.
9. Geopolitical tensions
This one is a slower burn than might have been feared after 9/11, but is real nonetheless. The war on terror and the on-going problems in Iraq have reversed the “peace dividend” that followed the end of the Cold War. Defence budgets are on the rise. Increased security measures slow the wheels of commerce – who wants to go on a long-business trip if you can’t take your laptop into the cabin? The perceived geopolitical risks may also result in investors demanding higher risk premiums to invest in risky assets. All of which evoke comparisons to the Vietnam era, which turned into a dampener for shares.
Implications – positive for defence stocks but little else.
10. The environmental imperative
Global warming has moved beyond an issue for environmentalists and is fast becoming a worrying reality for everyone. This threat and environmental crises generally are increasingly forcing governments to make companies pay the full cost of their activities.
Implications – environmental pressures will add to business costs (eg higher water rates, higher costs for carbon producers) and increasing environmental costs will favour those companies that are environmentally responsible. Running environmental screens across companies in setting up investment portfolios will likely become main stream in 5 to 10 years.
11. Weak house prices
I have covered this issue extensively – house prices in the US, UK and Australia are now very expensive relative to rents and wages and are likely to undergo a lengthy period of weakness. With rental property yields now very low, housing is likely to provide poor medium term returns.
Implications – at a general level housing is unlikely to offer strong returns for investors.
12. Modest returns from mainstream equities & bonds
The combination of low bond yields and high PEs compared to 10 or 20 years ago and a less favourable macro environment (flowing from the end of disinflation, deregulation having run its course, geopolitical risks, very high profit shares, etc) mean that medium term returns for mainstream shares and bonds are likely to be relatively modest. Likely average annual returns on a sustainable basis are high single digits for mainstream shares and around 5% or so for bonds.
Implications– favour assets that offer decent yields (ie, better valuations) and/or clearly identifiable growth advantages or scope for greater “alpha”, eg, Australian shares, non-residential property and infrastructure and Asian shares as opposed to US shares and traditional government bonds.
By Dr Shane Oliver, head of investment strategy and chief economist, AMP Capital Investors.*
[1] See “10 big ones – mega themes to keep an eye on”, Oliver’s Insights, August 2004. For those who wish to keep tabs, the only big changes from the 2004 edition are that I have softened my view on inflation and profits and I have added the environment as another theme.
