It’s time to get real about expected returns
“Investing in today’s world is like canoeing o¬n a river with a weak current, you have to really paddle hard and know what you are doing to get to where you are going, with no help from the environment.” Peter Brooke
Despite the volatility and ructions that have characterised the global financial arena over the past six months, the outlook for medium-term returns from most asset classes remains largely unchanged - and low from an historic perspective, according to Peter Brooke, Head of OMIGSA MacroSolutions. “This is because the macro themes we first named in 2010 continue to play out on the world stage and, in fact, have intensified,” he explains.
The first theme, from which all that follows, is that of Big Government, which is super evident in the more than US$6 trillion in excess leverage in the developed world. This tragedy is front and centre of the world’s attention, with the Eurozone debacle at its epicentre.
“We don’t see an easy solution to this,” says Brooke, “and we tend to agree with Mervyn King’s view that we are only half-way through this mess. The macro-growth environment has deteriorated to a greater degree than we had expected. This has resulted in lower GDP growth and earnings expectations. A silver lining is that expectations have now rebased to a very low level and, by year end, should be troughing. This means that the market can then look forward to an improvement.”
For now, though, the result remains that investors can continue to expect below-trend economic growth, continued political turmoil and volatile markets. The consequence of the excess leverage is exceptionally low interest rates globally, which reinforces the themes ‘cash is trash’ and the ‘quest for yield’.
Says Brooke, “These two themes are coming through in spades; we’ve seen more than 35 interest rate cuts around the world in 2012 so far, and don’t rule out more. The key cuts have been China implementing two rate cuts within a month (June), which was faster than expected. Also of note was the European Central Bank (ECB)’s 25 basis point (bp) cut of its refinance rate, and the reduction of its deposit rate to 0%. This has caused many money market funds to close their doors to new business.“
These exceptionally low rates have led to a desperate hunt for yield by investors, which has seen many bond markets trading at unprecedented low yields. In Switzerland, nominal bond yields are negative out to five years, while in Denmark the interbank lending rate is currently pegged at -2 bps, which effectively means that you have to pay a Danish bank to keep your cash.
South Africa has not been immune to these themes, with bond and property yields falling by 80bps, to 7.2% and 6.7%, respectively. This led to impressive capital gains, with listed property delivering a phenomenal 19.2% for the first half of 2012. “But,” says Brooke, “unfortunately these re-ratings mean that we will see lower returns going forward, the consequence of which is summed up in our theme of ‘a low return world’.
“We have cut our five-year, real return forecast for local property and bonds by 0.5 percentage points each to 5% and 2%, respectively. Importantly, investors need to note that these are well below historic levels, although they are still attractive compared to negative real returns on cash and bonds globally. As a result we wouldn’t be surprised by a continuation of foreign flows into the local bond market.”
Brooke’s expected real return for both local and offshore equity remains unchanged at 6.5%, but the caveat is that the risks to this return forecast remain high due to the prevailing macroeconomic environment. And, when it comes to offshore equities, he says that the majority of returns will be via dividend yield and not capital appreciation, which sees equities outperforming, but not delivering juicy returns.
“This environment leaves savers trapped in a volatile, low return world, yet they can no longer take refuge in cash,” says Brooke. “So we all have to save more, because there is no more free lunch. And, given that there is no one asset class that stands out as a good bet, investors would be wise to make sure that their investment portfolios are well diversified and that they invest with asset managers who undertake solid research, as well as have an active approach to management, so that tactical advantage can be taken of opportunities should they arise.”
Asset managers are in for a tough time, he says. “Managers will have to look harder for growth and employ their full tool box of instruments such as emerging market debt, convertibles and alternative asset classes in order to deliver on their mandates. A more active approach to management is also required to add alpha, which means that we will have to trade more. And, obviously we must diversify to mitigate risk.”
To conclude, Brooke adds that a key focus of all investors is to beat inflation, but that expectations should be realistic and that this low return environment should be factored into your personal financial plan. “However,” he says, “this is not to say that there won’t be opportunities to be found, for those who are prepared to act and know where to look.”
