In the quest for yield, don’t bet against the world recovery

With real interest rates both locally and globally expected to remain unattractively low (and even negative) for quite a long time, it’s a mistake for investors to continue to bet o­n cash for real returns - in effect this is a bet against the world economic recovery, according to Peter Brooke, head of Macro Strategy Investments at Old Mutual Investment Group (SA) (OMIGSA).

Instead, Brooke says, in today’s quest for inflation-beating returns equities should remain at the core of investors’ portfolios, as this asset class offers by far the greatest chance for the best returns over the near- and longer-term as economic growth slowly reappears around the world.

“In South Africa now, our effective real interest rates are negative, with inflation at 8.0% and cash at 7.5%,” he notes. “Cash yields are now below those of bonds and property for the first time in 3.5 years. Historically our real cash yields have been phenomenally high, averaging almost 5% over the past 15 years. But those days are gone - over the next couple of years real interest rates will be closer to 2%, with downside risk in the short-term.”

The devastating impact of these low interest rates o­n existing savers cannot be ignored, particularly because they are used to receiving fat returns, says Brooke. These investors will have a desperate need to replace their cash yields, and equities are the best replacement over time, even given the higher risk, he believes.

“Even though our equity market has already posted some good gains, having risen by 33% since its low in March, it is still o­nly near its historical average currently and offers fair value. This means it will still produce attractive real returns over the medium- to longer-term – we are forecasting a 7% real return from local equities over the next five years. This is somewhat lower than the 8% we expected at the beginning of the year.”

This forecast incorporates Brooke’s concerns around the ability of South African corporates to grow their earnings as strongly into the future, due largely to soggy global GDP growth and the much higher earnings base they are working from.

Still, he says, recent data shows the global economy is already starting to stabilize as the unprecedented policy stimuli from governments take effect. “It’s clear that the system is unclogging. Banks are lending more, investor risk appetite is improving (with the highest inflows into emerging market funds ever recorded in the second quarter of this year) and consumers are starting to benefit from low interest rates. Internationally, there is a wall of uninvested cash waiting to find a home, which will support equity markets in pullbacks. It’s not a smart idea to bet against this recovery by being out of equities.”

Offshore equities also look more attractive than the local market, Brooke says, due to their current cheap valuations relative to historic levels. He is expecting an 8% real return from this asset class over the next five years, with a preference for emerging markets given their stronger economic growth prospects. Foreign equity has been the worst performing asset class over the last 10 years and many investors are starting to give up o­n it. This would be a mistake.

The prospects for local property have deteriorated in recent months due to falling property valuations and tenant troubles, and Brooke expects a rough 18 months ahead for the sector. However, over the longer-term property remains a valuable asset for a portfolio with its forecast yield of 9% underwriting a real return of 6% over the next five years.

Meanwhile, bond yields have improved due to the recent sell-off and should produce a real 3% return over the next five years, just ahead of cash, he predicts. Investment-grade corporate bonds are more attractive, although they are much less liquid. And cash, with a projected real return of o­nly 2% through 2013, is of least preference for a portfolio.

“Retail investors need to understand that returns from most asset classes, but especially cash, will be lower for the foreseeable future,” he cautions.”This is also a concern for defensive funds which hold more than half their assets in cash*. To compensate for this and meet their long-term return goals, investors will be forced to take o­n more risk. It’s important for them to take a longer-term view and recognise they need equities in their portfolios now, more than ever before.”