Our most recent economic and investment forecasts were collected in January this year from New Zealand-based banks, brokers and fund managers. They show that forecasters are becoming increasingly gloomy about the prospects for investment market returns over the next 12 months and over the next five years. For New Zealand equities, expectations are the lowest that they have ever been.
This pessimism reflects the general view that we are in a period of low global economic growth, and very low inflation – and this seems likely to continue for some time. In that kind of environment, strong returns from equity markets are seen as unlikely. And with interest rates at very low levels, returns from bonds are also likely to be low.
The obvious implication (assuming the forecasters are correct) is that investors should be prepared for a period of lower investment returns than they have been used to in recent years. However there are two possible reasons to be more optimistic:
The forecasters are not always correct. For fixed interest markets, there has been a clear relationship between the forecasts and the subsequent returns, but for equity markets, there has been no discernable correlation between the forecasts and the actual returns over the subsequent 12 months or 5 years.
Share prices are driven to a large extent by surprises, especially in the short term. With so much gloomy news already priced in, if global economic growth was to be better (or less bad) than expected this could be positive for share markets.
For the next 12 months, the forecast return for each asset class is significantly lower than the average forecast over the last 20 years. On a notional ‘balanced’ portfolio (with 50% in growth assets and 50% in income assets) the overall forecast return is just 3.5%, compared with a long run average of 7.2%. In October 2008, the forecast was 10%.
For the next five year period the current forecast for each asset class is between 2% and 3% lower than the long term average, and the overall forecast is for a return of 5.2% p.a. which is well below the average forecast of 7.6% p.a.
What does this tell us?
Clearly, expectations of future returns from the major asset classes are very low and appear to be trending lower. There are many reasons for this, but with interest rates at or close to all-time lows in many markets, equity valuations high on many measures, and global economic growth expected to be subdued for the next few years at least, these low return forecasts are not surprising.
When it comes to equity markets, the forecasts should probably be taken with a pinch of salt. There are good reasons for equity market returns to be lower over the next five years than they have been over the last five – and on balance, we do expect that this will be the case. But we also know that there are factors other than fundamentals that drive share prices so the actual outcome is far from predictable.
For fixed interest investments there is more reason to take notice of the forecasts. Yields are low, and returns are likely to be low as a result.
What does this mean for portfolio management?
First, it does not mean that portfolios should not hold bonds. Bonds are held primarily to provide protection, and they will continue to fulfill that role – even if the amount of protection they can offer is reduced.
Second, with equity portfolios the key is to find skilled managers, and give them broad mandates so that they have the opportunity to add value during what may be a challenging period.
Finally we often recommend an allocation to alternative assets (i.e. assets other than cash, bonds and equities), in order to improve portfolio diversification and provide additional sources of return.
This is an abridged version of an analysis written by Guy Fisher. The full article including illustrative graphs is available here.
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