Specialist Outlook

Sarasin & Partners: Our expectations for future investment returns

26 January 2017

If investment returns from 2016 are added to those from previous years, then investors should be in a healthy financial position. Over the course of the year, UK government bonds were up 10%, the FTSE All-Share up 17% and the MSCI All Countries World Equity Index up a very healthy 29% in sterling terms. (The latter was inflated by the dramatic fall in the value of sterling following the UK voting to leave the EU.)

What’s more, over the last five years, the FTSE All-Share has returned 10% per annum and the S&P 500 (in sterling terms) an incredible 20% per annum. Given that UK inflation (CPI) has averaged 1.4% over the same period, investors in these markets have made real returns well in excess of normal expectations.

So, here lies the challenge – what can investors expect over the longer term, given the real and absolute returns that have been achieved in the recent past?

Understanding future return expectations

Our trend returns are the average annual total returns we expect investors to achieve over the next 5-10 years.

These are ‘strategic’ trend returns, and not what we anticipate investors to achieve in any one year. They are the basis for our strategic asset allocation decisions and are the central points around which we take our tactical judgements, which are based on shorter-term views of the macroeconomic environment, profit and dividend forecasts, valuation levels and sentiment indicators. They are effectively ‘index’ returns and are quoted before any costs associated with investment or the impact of selecting one passive or active fund over another.

The most important inputs to our expectations are our views on global growth, global inflation and UK inflation.

Deconstructing real global growth

Long-term economic growth can be broken down into two components: growth in the population or labour force and growth in productivity.

We expect to see labour force growth slow to 1% over the next 10 years, down from its long-term average of 1.6% per annum. Productivity growth is more challenging to calculate, but we anticipate global productivity to continue to grow by 1.5% per annum, roughly in pace with its long-term average of 1.6%. This would lead to a global growth rate of 2.5%.

However, we envisage medium-term headwinds from rising global debt levels, and compositional changes in demographics (for example, population growth is tilted towards low income countries) to reduce the average rate of global growth to 2.0% over the next decade.

Forecasting returns by asset class: why inflation matters

A forecast for inflation is required to ‘inflate’ the returns of several of the asset classes and also to ‘deflate’ the end result to create a ‘real’ return. Forecasting inflation is likely to be just as contentious as forecasting individual asset class returns – of which inflation is an integral part. As per our work in the 2016 edition of the Compendium of Investment, we estimate future global inflation to average 1.5% over the next 5 years.

Government bonds: the end of the bull run?

Our trend returns for UK government bonds simply take the gross redemption yield (GRY) on the benchmark 10-year issue and assume it is held to maturity. As at the end of 2016, the Treasury 1.5% July 2026 was priced at 102.34, with a GRY of 1.2%.

In the final part of 2016, both the UK and US government bond markets fell. This was driven by the election of Trump in the US (and his pro-growth policies) and the prospect of higher inflation in the UK following the fall in sterling. We believe this heralds the end of the multi-decade bull run in government bonds (yields probably troughed in the summer), but equally we do not forecast a dramatic bear market given the long term trends in debt, demographics and further deflationary forces.

Corporate bonds: part of a diversified portfolio

We assume that an investor would invest in a diversified manner across a range of corporate and asset backed bond issues. The average maturity of the portfolio of bonds would be 10 years, with an average credit rating of A-. The GRY on such a portfolio would be at a 2% premium to UK government bonds - in today’s market this would lead to a GRY of 3.2%.

Global equities: anticipating 6% over 5 years

For global equity returns, we take the net income yield of the world stock market as at today (circa 2.4 %) and then assume any exit of the stock market is achieved at this same yield. As such, capital appreciation will equal dividend growth.

We estimate dividend growth by taking the expected level of global inflation (1.5%) and then add in our forecast rate of ‘real’ dividend growth (2.0%), which is equal to our forecast for real global growth detailed earlier. We conclude that it is reasonable to expect a trend return of 6% from global equities over the next 5 years.

UK physical property: following the equity formula

In our approach to UK physical property, we use a similar formula to that for equities. First, we take the net income yield of the UK commercial property market (roughly 4.5% today), then we assume any exit is achieved at this same yield. As such, capital appreciation will equal rental growth. We estimate rental growth by considering the ‘real’ growth witnessed in the past (-1% per annum) and add this to the expected level of inflation we expect to see over the next 5-10 years. We conclude that a diversified portfolio of UK commercial property would generate a total return of 5.0% per annum.

Alternatives: returns dependent on investor preferences

Investors are likely to hold a wide variety of different alternatives in their portfolio and we expect returns to be idiosyncratic to the preferences of individual investors. As such, the trend return we have put in is very much an educated guess – we estimate 4.5% per annum (a 3% premium to UK government bonds).

Expect low returns from traditional multi-asset portfolios

The recent historical absolute and real returns from the majority of the traditional asset classes means that we are making our predictions from an elevated position.

Coupled with the low returns available from fixed interest assets and a lower expectation for real economic growth, unfortunately one has to conclude that both absolute and real returns from a traditional multi-asset portfolio will be more muted over the next few years.

While we have used global inflation as the ‘inflator’ for our asset class returns we also need a level of inflation to use as the ‘deflator’ when considering the ‘real’ returns. We would specifically caution UK investors on this point: the deflator should be the amount of inflation (or deflation) each individual investor’s circumstances dictates. This is particularly relevant today, given the spike in inflation that we expect in the UK over the next year following the fall in sterling and the recent rebound in commodity prices (and consequently imported goods) for the UK.

This leaves UK investors in a disadvantageous position; experiencing a high domestic level of inflation with their investment assets only benefiting from global levels of inflation (1.5%). We estimate that UK inflation will average 2.5% per year over the next 5 years. However, one should also note that UK investors have had a one off boost in the value of their equity investments this year as a direct result of the fall in sterling, thereby boosting the starting capital values of portfolios.

Table 1 uses our endowment model to illustrate how the future returns from a typical charity portfolio might look.

To put this in the context of history, our endowment model has produced average annual absolute returns over the last 5 years of 10.5%. This equates to a real return of 8.4%, well ahead of our expectations and again illustrates that investors have experienced very good absolute and real returns over the recent past. When compared to history (as shown in Table 2) it is clear that there are periods of both feast and famine.

Combatting low returns through planning, income, and investing thematically

While we are forecasting rather meagre ‘real’ returns for the next few years, there are some things that trustees and investment managers can do to help mitigate this:

   1. Ensure that if your charity has any planned spending commitments over the next 18 to 24 months that necessary cash is raised soon – we do not forecast an imminent correction, but markets do have a habit of rebasing, particularly after a period of such strong returns

   2. Focus on income. With the future for capital returns more uncertain ensure that the income stream from your portfolio is robust, sustainable and diversified.

   3. Focus on thematic stock selection to drive superior long-term returns.

We believe that a focus on these core areas could help alleviate the likely challenges in achieving compelling real returns ahead

 

 

 

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James Hutton

James Hutton
Business Partner
James is responsible for the management of portfolios on behalf of charities and UK and international private clients. He is also a member of Sarasin & Partners’ Investment Policy Committee.

Prior to joining Sarasin & Partners in 2012, he spent 7 years at GAM London Limited where he was a Portfolio Director managing a diverse range of private client and charity portfolios. He started his investment career working for Newton Investment Management.

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