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Strategic asset allocation – it’s still a low return world

Thursday 19th of February 2004

Setting an investment portfolio’s strategic asset allocation (SAA) to each asset class (global shares, bonds, etc) within a diversified investment portfolio is the most important decision most investors make. We have previously argued that this should not be a set and forget decision but should be reviewed annually with respect to a range of factors including changes in markets (or valuations).

It might be tempting to think that the double digit rebound in share markets over the past year indicates that we can look forward to a return to the sustained high returns of the 1990s. However, our analysis indicates that while the bear market is probably behind us we are still in a low return world and that SAA should be set accordingly. Economic and financial backdrop

The economic and financial backdrop continues to point to lower returns over the next ten years than was the case in the 1980s and 1990s.

Over the 1980s and 1990s returns from equities and bonds were boosted way above long term (and sustainable) averages by the adjustment from high inflation to low inflation which allowed a sharp fall in interest rates. This produced big capital gains in bonds and equities as bond yields and earnings yields also fell. The adjustment meant that share prices rose a lot faster than growth in underlying corporate earnings (reflected in the rise in price earnings multiples). This once-off adjustment has now run its course with global inflation around two per cent. Any further fall in inflation (ie deflation) might be good for bonds but would not be good for equities, whereas a rise in inflation would be bad for both asset classes as bond and earnings yields would have to rise (PEs fall);

In the early 1980s price earnings multiples on stocks were low (dividend yields were high) and bond yields were high thus setting the scene for the high average returns of the 1980s and 1990s. Today this is not the case;

Starting in the 1980s, the ascendancy of free market economics as represented by tax cuts, deregulation, privatisation, free trade and smaller government was positive for private enterprise and hence equities. However, many of these policies have now run their course or are subject to some public backlash;

The collapse of Communism in the late 1980s ushered in the so-called “peace dividend” in the form of reduced government spending on defence thus freeing resources for use by the private sector. With the “war on terror” this is now subject to some reversal with defence spending now rising again and the heightened terrorist threat adding to investor uncertainty; and

The sharp fall in share prices between March 2000 and March last year weakened investor confidence in shares and the experience of the 1930s and 1970s suggests that it will take a while to fully recover.

Indicative return expectations

For most assets current prevailing investment yields provide the best guide to returns for the next five to ten years.

For equities, a simple model of current dividend yields plus trend nominal GDP growth does a good job of predicting medium-term returns. This approach allows for current valuations (which are picked up via the yield) but avoids getting overly complicated. The next chart shows this approach applied to US equities. It can be seen that it broadly tracks the big swings in equity returns (and points to lower returns ahead);

Source: Datastream, Global Financial Data and AMPCI

For property, a similar approach works well using current rental yields and likely trend inflation as a proxy for rental (and hence capital) growth; and

For bonds the best predictor of future medium-term returns is the current bond yield.

Using this framework and assuming trend economic growth and inflation (2.5 per cent pa) for each country our projected (pre tax and fees) returns over the next decade for the major asset classes is as follows. Projected medium term returns, %pa

Dividend yield +

Growth # =

Return

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