Another year of strong returns – can it continue?

SUPERANNUATION and diversified investment funds had another year of strong returns last financial year.

Introduction

Despite expectations that returns would slow, the last financial year saw very strong gains from diversified growth investment funds with median gains of 14.8% pa (after taxes and wholesale investment management fees) according to the Mercer Investment Consulting Pooled Fund survey. This comes on the back of median returns averaging 14.4% pa over the previous three financial years. Other super fund surveys show similar results. After such strong gains, naturally there are concerns it may soon go into reverse.

Source: Mercer Investment Consulting, AMP Capital Investors

Why have returns been so strong?

Essentially there have been three key drivers of the strong returns of the last four years:

·       Firstly, there was a pretty typical rebound in equity markets from their March 2003 low.  

·       Secondly, shares have been boosted by a surge in profits. As a result the ratio of share prices to earnings remains well below previous peaks.

·       Thirdly, non-residential property investments and investments like infrastructure have benefited as yields declined, in lagged adjustment to the decline in inflation and bond yields in the 1980s and 1990s.

While much has been made of “easy money” and the world being “awash with liquidity” our view is that while this may be starting to play a role it has not been the dominant driver over the last few years. We are yet to see a generalised liquidity driven blow-off in PE multiples.

Returns must slow…sooner or later

While I have been bullish on the outlook, I have been (pleasantly) surprised at the strength of returns. However, it would be wrong for investors to assume that the very high returns of the last few years will be sustained at this pace indefinitely.

·       First, the returns of the last few years are well in excess of what the long term historical record would suggest is normal. The table below compares nominal and real returns from a diversified growth mix of equities, bonds and cash since 1900. This suggests that a 5.5% pa real return is a realistic expectation going forward.

Long term returns from “diversified funds”, %pa

Returns are pre taxes and fees. Source: Global Financial Data, Thomson Financial, Mercer Investment Consulting, AMP Capital Investors

·       Secondly, medium term (ie 5 years or so) return projections suggest sustainable rates of return going forward will be far less than has been the case recently. Our projected medium term returns for key assets are shown below. These are based on current starting point yields plus capital growth in line with nominal GDP (for shares) and inflation (for property) asset classes.

Projected medium term returns, %pa

Source: Thomson Financial, AMP Capital Investors

The projected returns imply about an 8% pa nominal or 5.5% pa real return for a portfolio with a traditional 70/30 mix of growth/defensive assets. This is pre taxes and fees but excludes any form of added value (alpha) which may add 1% pa or so to returns.

These return projections reflect the following realities:

Ø     Profit growth cannot exceed nominal GDP growth forever otherwise there will be no return to labour – and profit shares are already at record levels;

Ø     Over the long run capital growth will be in line with growth in earnings (or rents in the case of property) – otherwise investment yields would approach zero.

But of course, as we have seen over the last few years historical and projected returns are not of much use in predicting year to year returns.

·       Finally, profit growth is starting to slow in the US and Australia and with global interest rates having increased monetary conditions are not as easy as they were a few years.

So where to for investment returns?

Our base case is for returns to slow down in line with slowing profit growth. However, there is no reason to expect a major slump in returns. Bear markets in shares and periods of negative returns for diversified funds are usually preceded by, or associated with, some combination of share market overvaluation, broad based investor euphoria, sharply rising and much higher interest rates and recession.

None of these signs are currently present.

·       Equity markets are not overvalued, eg, the price to earnings multiple for global and Australian shares remain moderate and well below previous peaks;

Source: Thomson Financial, AMP Capital Investors

·       There is nowhere near the sort of investor enthusiasm for shares normally seen at major market tops. In fact surveys show investors are still a bit cautious. Certainly the number of questions I am receiving from “concerned” investors about the share outlook would suggest there is still healthy scepticism about shares.

·       Inflation is not a major problem, which means interest rates haven’t and are unlikely to reach threatening levels and may even decline later this year in the US.

·       While the US has slowed, there is no sign of recession and the growth outlook globally, particularly in emerging countries led by China, and in Australia remains strong. This suggests that while profit growth may slow, it will still be solid. In fact, profit growth in Australia is likely to be 15% over the next year, assisted by high commodity prices and solid growth in domestic demand.

While returns over the last four years have been the strongest since the four years to June 1987, the magnitude this time around is much less than it was back then. Real (ie, after inflation) post tax and wholesale fee returns over the last four years have averaged 12.3 per cent pa compared to a whopping 18.6 per cent pa over the four years to June 1987. Most importantly share market returns over the last four years have been underpinned by gains in profits, in contrast to the 1982-87 bull market which saw shares rise three and a half times faster than profits.

Finally, direct property, private equity and infrastructure continue to provide strong return potential going forward.

All of these considerations suggest that investment returns are likely to remain reasonable over the year ahead.

What are the risks?

The main downside risks worth keeping an eye on are:

1.    A hard landing in the US economy led by the housing slump, which could threaten global growth. While this is worth monitoring, our assessment is that it is unlikely to drag the US economy into recession. Most US home owners are not having trouble servicing their loans and the US corporate sector is in good shape. While sub-prime mortgage losses will get worse before they get better and are likely to amount to around $US100 billion, this is just 1% of the $US10 trillion mortgage market, and is just 0.2% of total US household wealth.

2.    A sharp slowdown in China threatening commodity prices. A slump in China has been a worry for the last few years, but our assessment has been and remains that with China’s underlying inflation rate remaining subdued (running at just 1%), the risk is still pretty low.

3.    A sharp surge in oil prices. This is the time of year when oil prices spike higher. A moderate rise say to $US85/barrel wouldn’t be enough to cause major problems but a quick spike higher, say on tensions regarding Iran, to $US100/barrel could.

These risks are all worth keeping on eye on and indeed worries about them could provide the trigger for the next correction in shares