One of the big challenges we see for investors today is the disconnect between the investment returns that have been realised over the past few years, and the likely investment returns that await us in the years ahead. At face value this disconnect is easily understood. Recent history has been spectacularly good for most asset classes. Notably, the stock, bond, and property markets –three investment classes that dominate most people’s portfolios – have all delivered recent returns that are well above their long-run averages. Moreover, these exceptional returns have come against a very benign investing backdrop. It has been quite some time since the average long-term investor has suffered any real financial pain. While it is true that the pandemic caused a severe market correction, global equity markets had recovered to their all-time high within six-months of this event. That feat took three years following the GFC, or five years following the ‘dot-com’ crash.
With returns plentiful and perception of risks low, it is understandable that investors’ expectations have been steadily rising. The 2021 ‘Global Investors Study’1 from Schroders highlighted that its respondents expected average annual investment return of 11.3% over the next five years, a figure that has increased in each of the past three years Schroders has run this survey. Perhaps unsurprisingly, the study shows that people’s return expectations are at their highest in the countries that have enjoyed the strongest local market gains in recent years.
Try as we might, we are all emotional actors. That recent investment returns have been unusually good is not a particularly robust platform to base our future return expectations on. Worse, the driving force behind these recent stellar returns has been a period of relentless falls in interest rates all around the world. This has provided a one-time boost to most asset classes, as lower discount rates have reset asset valuations higher.
Lower interest rates mean higher asset prices…
It is a truism that as the cost of money falls, the value of assets simultaneously rises. For many of us this is most clearly understood in terms of the property market. Lower mortgage rates provide home buyers with the ability to pay higher prices for houses. This same principle applies across all asset classes. As money gets ‘cheaper’, asset valuations move correspondingly higher. Long duration (or length) assets benefit from this the most, as they have the greatest sensitivity to this effect.
In recent years, many of us have benefited greatly from this phenomenon, given the large exposure most people have to the property and the share markets – two very long duration asset classes.
…higher asset prices mean lower long-term returns
Finance theory says that the return you expect to earn from an investment should be anchored to the return you could receive from holding the current ‘risk-free’ rate. For most of us, that is the interest rate you can receive in a term-deposit account – essentially zero today. As you take more risk with your investments, you should expect to earn an additional margin of return to compensate for this. Thus, the interest rate you receive from owning high quality bonds (loans) today is c.2%2 pa. While that provides us with a 2% margin over the risk-free rate of return, it is a figure that has fallen considerably from the c.3.5% you would have received for making the same loan five years ago, or the 5% you would have earned ten years ago. Further along the risk curve are ‘high yield’ bonds, essentially loans that are made to companies where there is a reasonable chance the borrower may default. This risk of borrower default is why ‘high-yield’ bonds are also sometimes referred to as ‘junk bonds’. Today, the yield on these loans is 3.75%. This offers an additional return margin of 1.75% over high-quality bonds, but, again, is still considerably lower than the 5% interest rate we would have received owning these same loans five years ago, or the 8% on offer ten years ago.
The investment proposition we face with high-yield loans today provide us with a helpful framework to think about investing even further out along the risk curve, notably into asset classes like the share market. Earning an interest rate of 3.75% from lending to risky borrowers can hardly still be thought of as a ‘high-yield’ proposition. Yet, while the interest rate we receive has plummeted, the risks from holding these loans are largely unchanged. Of the two market acronyms used to describe the asset class – ‘high-yield’ and ‘junk’ – only ‘junk’ continues to remain apt. We are bearing a high level of investment risk, while expecting a low investment return.
If the academic textbooks are right, this same framework should apply to the highest risk asset classes, like the share market, which also have been the places that investors have received the strongest gains in recent years. Over the very long-run, global share markets have generated annualised returns of 7.6%3 a year. However, over the past five years, this figure has been 14.5%. We would argue that it is the disconnect between these two numbers that has led to the steadily increasing future return expectations we see in many investors today, as illustrated well in the Schroders study.
Unfortunately, when we look at the equation soberly, forecasting longer-term share market returns is not just a case of dragging our expectations back down to previous long-term averages. Because share market valuations are so much richer today than they have been historically, an attempt to forecast future returns based on fundamentals suggests we are in store for a period of returns that are much lower than this. And of course, despite these much lower return expectations, we are still left bearing the high risks that come with investing in this asset class.
The long and short of it
When trying to predict things like future asset class returns, most professional forecasters focus on likely long-run assumptions. The reason for this is simple, they are typically more accurate than any attempt to forecast the short-term. Looking out over the long run (typically five to ten years) allows reasonable assumptions about things like asset class valuations, or sustainable rates of earnings growth, to play out. Factors that, historically at least, have been shown to have a reasonable bearing on future outcomes.
As an institutional investor we are privy to many of these forecasts, and it is common for us today to see low-single digit return assumptions attached to share market expectations for the years ahead. Perhaps one of the most high-profile forecasters is GMO asset management, a firm that generously publishes all of its forecasts for everybody to see (and hold them to). Using a set of assumptions that would be common for most professional investors, they project annualised global equity market returns of minus 2.8% over the next seven years4.
Professional forecasters, of course, have an embarrassing proclivity for getting things wrong. However, the colossal gap between fundamentally-based forecasts and investors’ current expectations is worthy of reflection. Particularly since, it would seem, the basis for many investors’ current high expectations is simply that recent returns have been unusually strong. The common disclaimer that ‘past performance is not indicative of future results’ could, perhaps, never have been more apt.
1 Each year Schroders Plc commissions a large independent survey of over 23,000 investors from 32 locations around the globe. The key findings of this survey are made public.
2 All interest rates refer to US$ rates.
3 As measured by the MSCI All Country World net return index in US$ terms. Returns are from the index’s inception on 31 December 1987, through to 30 June 2021. Net returns (excluding withholding taxes) are only available from August 1998, before then gross returns are used.
4 GMO 7-Year Asset Class Forecast | 20 July 2021.
Miles Staude of Staude Capital Limited in London is the Portfolio Manager at the Global Value Fund (ASX:GVF). This article is the opinion of the writer and does not consider the circumstances of any individual.