How will investment returns be generated in the future?
Is Volatility here to stay? Sarasin & Partners look at what trustees should consider when estimating trend returns for charity portfolios.
The year has opened beset by volatility, testing the nerves of short-term investors, particularly those who perhaps walked into 2016 with short-term spending requirements and a little too much exposure to equities. However, for the seasoned longer-term investor, the sharp falls witnessed in January and early February, followed by a full rebound in late February and March, were all par for the course: volatility is the price one has to pay in order to generate attractive long-term returns.
So what will these long-term returns be over the next decade? What is the reward for the investor who successfully avoids being whipsawed by market sentiment and press commentary? And if we predict a positive return, how much of this can be spent, leaving enough capital to be spent as generously by future generations?
Our recent publication of the 20th edition of the Compendium of Investment provides in-depth analysis of our forecast for total returns for the decade ahead. In this article we have summarised the key factors Trustees might consider when estimating trend returns for charity portfolios.
The core assumptions that drive our long-term projected equity returns are:
1. There will be economic growth
2. Companies will maintain their share of economic growth, thus corporate profits will grow broadly in line with economic growth
3. A stable share of profits are paid out each year as dividends, so dividends will grow broadly in line with economic growth
4. Over the longer term, the yield of the market remains constant, thus dividend growth will drive capital appreciation
5. The total return from equities equals the starting yield, together with the capital appreciation
So how, first, to forecast economic growth? GDP is a measure of economic activity within a given period of time. That is, the monetary value of everything produced in the economy. It should also equal the monetary value of everyone’s income. It is quite distinct from wealth (which is the stock of value rather than the flow) or consumption (which is just activity used for present consumption). For this exercise, we will consider ‘real’ as opposed to nominal economic growth. Nominal growth is the result of changes in prices (inflation) as well as changes in volumes. The two are clearly linked and we will return to the inflation element and thus nominal levels of growth later.
Growth is typically broken down into two components: growth in the ‘labour force’ and growth in ‘productivity’. When analysing the labour force, we can split the world into two types of people: those who work and those who do not. This means that productivity can be calculated by dividing total GDP by the number of workers, giving the average production of each worker.
At this point, given the international make up of large, listed businesses, we will analyse global GDP, rather than that of individual countries. However, given the different trends that exist, we will adopt a crude split between developed markets (DM) and emerging markets (EM). Our relatively simple geographical split is not to suggest that the situation will be the same in all developed markets, or in all emerging ones, it is simply to manage the scope of the report at the cost of losing some granularity.
Let’s start with our estimate for labour force growth. We expect to see a shrinking labour force of between -0.4% and 0% in the developed economies, supported by rather better demographics in the emerging world of between 0.5% and 0.9% growth per annum. There is relatively little scope to adjust these numbers: the demographics are already ‘baked in’ and if we flex the model for changing employment patterns and lifestyles (such as more women working, people working longer and starting to work later) we see relatively little impact.
Productivity growth is more challenging to calculate; in developed markets, the long run average is about 2% but has fallen recently and we are currently factoring 1.2% into our models.
In emerging markets we expect to see continuation of the recent ‘convergence’ between DM and EM productivity, as the EM adopts better educational practices and efficiently ‘leap frogs’ technology advances. This convergence has not always been present (in the 1980s and early 1990s, EM and DM disparities actually widened). However, going forward, we expect this trend to boost EM growth by about 1% per annum over developed markets, resulting in productivity growth of 2.25% per annum.
When taken together, this means that we believe the world will grow at about 2.5% over the next decade, which is the same as it has averaged over the last decade. See chart 1 for the full 50-year projections.
Turning economic growth into profits & dividend growth with our forecasts for global GDP growth, we now turn to corporate profits and dividend growth. We need to consider how various dynamics will play out which, step by step, link global GDP growth with a forecast for the growth in corporate profits and consequently the dividends they pay out.
Chart 2 shows how economic growth is whittled away to the ultimate dividend that you receive in your portfolio.
By way of background, last year the MSCI All Countries World Index paid out $1.14 trillion of gross dividends, equivalent to roughly 1.5% of global GDP: this percentage has been a consistently stable proportion over the last 45 years.
In our modelling, we consider which of these, or other factors could destabilise this relationship: will companies be taxed more (yes), will labour earn a greater share of corporate profits (no), will the cost of debt rise or fall (fall), will corporate pay-out ratios rise, or will companies choose to hold back cash to invest further in their businesses
(on balance, we see pay-out ratios increasing).
When taken together, we believe these factors will effectively net off against each other and we are therefore forecasting ‘real’ global dividend growth over the next decade of 2.5%. While this is the same as our global economic growth projections for the same period, we do differentiate between the growth we expect for UK listed companies (1.5%) and overseas listed companies (2.5%). This takes account of the different pay-out ratios, starting yields and sector composition of the UK equity market.
Taking account of inflation
Thus far our growth numbers have all been quoted in real terms, after inflation. To calculate what this means in nominal terms, we need to estimate the average inflation rate. We believe that CPI inflation is likely to be less than the Bank of England’s 2% target for the next 7-10 years because of structural forces impacting the global economy
such as globalisation and innovation. We assume an inflation rate of 1.5% which means that nominal or absolute dividend growth is likely to be about 3.5% over the next decade.
Projecting total returns
Using today’s starting yield for equities, and assuming we see no re or de-rating over the next decade, we can now drop our equity forecasts into our Endowment Model, which includes projections we have made for a wide range of asset classes.
For long-term, equity oriented portfolios, we are expecting total returns of about 5.7% per annum. These returns are before the impact of costs and any value added or subtracted by active management.
To calculate what a sustainable spending rate might be, charities will need to consider their own rate of ‘inflation’. This can vary widely, depending on the charity’s objectives and the particular mix of costs it is suffering and the services it is providing. Given today’s low absolute numbers, a half a percent here or there can have a substantial impact on a charity’s stable long-term spending rate. If we assume the average charity suffers the 1.5% rate of inflation referred to earlier, then the real return from this asset mix would be 4.1%.
It is probably wise to build in the costs relating to investment: one should not presume one’s fund manager is going to outperform. This means that a charity might spend a sustainable 3.5% per annum. If your fund manager does better than average, this figure could rise to 4% or more. Conversely consistent underperformance after costs could reduce it to 3% or lower.
In summary, whilst not a certainty, portfolio returns will likely be lower in the years ahead. What is certain is that volatility is here to stay.
Share this article
Richard Maitland is a partner and Head of Charities at Sarasin and Partners.
Richard has more than 22 years of investment experience and joined Sarasin & Partners in 1992. In addition to UK equity research, Richard has led the firm’s third party funds research team, analysing specialist equity funds and alternative assets while managing portfolios for a range of charities, pension funds and unit trusts. He now focuses on managing diversified multi-asset portfolios for charities and assists in setting the firm's long-term strategic asset allocation. He is author of the Sarasin & Partners Compendium of Investment. Richard has a degree from Newcastle University and is a member of the St Paul’s Cathedral Investments Committee. He has been a visiting lecturer on investment and endowment management at the Judge Business School and the Universities of Stellenbosch and Vienna.Read more articles by this author