In a year where the global economy entered into its deepest crisis since the Great Depression, stock markets have demonstrated remarkable resilience, and investors who held firm or added to their portfolios though the initial crash have generally been rewarded for their confidence.
The median balanced growth super fund returned 7.3% p.a. over the past ten years, which is high by current standards but might seem underwhelming to anyone who remembers the heady days of double-digit returns in the 1980s and 90s.
The thing to remember is that those returns occurred in the broad context of a high yield environments. In the early 1980s, the RBA cash rate hovered around 14%, 1-year term deposit rates were nearly 14%, 10-year bond yields were around 13.5%, commercial and residential property yields were around 8-9% and dividend yields on shares were around 6.5% in Australia and 5% globally. Yield was the dominant factor in asset performance, and only moderate capital growth was required to generate those double digit returns we remember.
So what changed?
The first, and perhaps most important part of the story, is that many governments, including our own, responded to high inflation by empowering independent central banks with mandates to target inflation. In Australia, inflation has rarely significantly exceeded the RBA’s target of 2-3% since it was introduced in 19931. The expectations that set in around this kind of environment have enabled the RBA to lower interest rates in pursuit of economic growth at a time of global stagnation, and to cut them aggressively at the start of this crisis.
Lower for longer interest rates have led to lower bond yields, and consequently lower yields on other assets. This has generally occurred as part of a “search for yield”, where in the wake of a fall in bond yields other asset classes become more attractive to investors, driving up prices. Prices and yield are inversely correlated – $10 annual income from an investment represents a proportionally greater return to an investor who paid $100 than to an investor who paid $110 – and the cycle perpetuates as interest rates fall.
Returns to investors at times like these become increasingly weighted towards capital gains, however there is a limit to this effect. Capital growth requires demand from investors wanting to buy into the asset class, but as yields across the board flatten towards baseline levels, the risk-adjusted incentive to buy assets will diminish at some point.
Our new low-yield normal
With a simple search for yield having less of an impact, other factors are required to generate capital growth. And at a macroeconomic level those factors are softening. For example, households are increasingly reluctant to take on more debt, and ageing populations and slowing population growth has resulted in lower growth in the labour force -which may be compounded by unemployed workers choosing not to return to work post-COVID. Political risks abound, not least of which are geopolitical tensions and a trend towards populist, anti-free market policies such as protectionism. The lasting effects of the COVID-19 pandemic within industries are also unclear, such as the impact of work from home, online shopping, and property values.
Considering these factors in the context of stable but lower yields, investors need to adjust their expectations for returns. Our medium term (5- to 10-year) return projections for a diversified mix of assets have now fallen to around 4.8% p.a. from 5.6% a year ago, which is still respectable in a time of very low inflation, and in comparison to the 1% many will receive on a bank deposit.
Within that aggregate, we can anticipate the performance of various asset classes:
Bond returns are likely to remain low, held down by ultra-low yields at near-zero interest rates.
In contrast, commercial property and infrastructure should fare relatively well, but face greater than normal uncertainty in demand for retail and office space & human transport infrastructure.
Australian shares still stack up well on the basis of yield, but there is greater growth potential in Asian and emerging markets.
How long will these conditions hold?
Whilst a global return to growth with low inflation is a more conventional path to a higher-yield environment, a risk is that inflation rebounds earlier, in which case higher yields would be accompanied by large capital losses. Just as likely is a scenario where a prolonged recession continues to drive down asset performance even further, leading to reductions in yields and/or capital value.
In the meantime, we should keep some perspective and bear in mind that real returns, accounting for inflation haven’t fallen by anywhere near as much the headline figures. The key focus for investors should be to temper their expectations and seek out assets with competitive and sustainable income streams, whilst being aware of the risks associated with higher-returning assets.
By Dr Shane Oliver Head of Investment Strategy and Economics and Chief Economist, AMP Capital.
Please contact us on 1300 882 166 if you seek further discussion on this topic.
Reproduced with the permission of the AMP Capital. This article was originally published at https://www.ampcapital.com/au/en/insights-hub/articles/2020/october/what-could-a-low-yield-environment-mean-for-returns
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