Prepare for modest medium-term growth

Investors are enjoying some short-term dividends … but the medium-term outlook is more sobering.

Summary: The current market rebound is a short-term correction. Over the medium term, expect returns from equities, bonds and property will be flat. Investors should prepare accordingly, based on their appetite for risk.
Key take-out: Low interest rates will force many investors back to the sharemarket, but company earnings will be under pressure.

Key beneficiaries: General investors. Category: Growth.

Economist John Maynard Keynes reminded us that “in the long run we are all dead”, which we might read as a warning that you can’t always expect to earn the long-run average return when investing.

Following on from a period of poor medium-term returns from growth assets and continuing concerns for defensive assets, I worry that you and professional investors might not earn in the medium term the returns you expect or need. By medium term, I mean over the next five or more years. So this view can coexist with the current optimism for the start of 2013. Here, let me explain why I’m worried and what steps you can take to manage risks.

Outlook for share, bond and property returns

While 2012 finished the year with especially pleasing returns from investing in companies and real estate trusts (about 20% and 30% respectively), I fear that the encouraging start to 2013 might only be a temporary correction of the depressed asset prices I alerted readers to in August (A pointer to higher returns). Going forward, companies may struggle to grow their earnings in an austere deleveraging world, which is necessary to drive more sustainable share price growth. Like it or not, there is only so much downsizing companies can do to counter squeezing profit margins, and increasing price/earnings ratios have their limit in boosting share prices.

In Australia, as the mining boom recedes and fears of a recession potentially emerge later in the year, it will be difficult for local companies to grow profits from belt-tightening consumers and corporates. History suggests (We’ve been here before) debt hangovers can easily last a decade, which means we shouldn’t expect too much from the US, Europe and Japan and their factory – China. This means future investment returns from growth assets could be much more modest than they have been in the past. This anaemic view is also shared by Vanguard in its recent 2013 economic and investment outlook, which forecasts annual equity returns of only 6-9%, below the long-term average. It does take hope from a view that inflation will be subdued, so these returns on an adjusted “real” basis may not be so bad. 

The medium-term returns from the other mainstay of investment portfolios, defensive cash and bonds, will be below average as interest rates hit new lows. Looking backwards, depositors enjoyed annualised term deposit rates of about 5-6%, or a generous 2-3% above inflation. Those that followed my encouragement (Bonds figure in balanced portfolios) a few years ago to invest in bonds earned an additional annual 3% premium by investing in traditional fixed-rate bonds, and an annual 5% extra investing in longer-maturity inflation-linked bonds (the annual return from Australian nominal and inflation-linked bonds averaged 8.4% and 11.6% over the last three years).

Unfortunately these returns aren’t repeatable – and I don’t mean maybe. That’s because the stellar returns from bonds included a capital gain associated with falling interest rates. New investors in bonds now earn a very modest yield of about 4% (the yield of the broad-based Australian bond index, which includes relatively safe government bonds, is yielding a measly 3%) and are forced to pay a premium for older higher-rate bonds. As interest rates can’t fall much further, the potential for further capital gains to enhance these low yields will be modest. Most worrying is that when interest rates inevitably rise and/or the fear premium built into bond prices subsides, bond investors will suffer a capital loss to depress the meagre income return, possibly into the negative. This means bond investors will be lucky to earn half the return over the next five years that they earned over the last five years. Deposits may be a safer place for your money but the best you might expect from this asset class is 4% for a while also.

The yield (%) on Australian government 10-year bonds has never been lower in the last 30 years. This has made bond investing attractive over the last 30 years, but not the next.

There are plenty of opposing opinions about the prospects for the property market. In my view residential property has been an excellent appreciating asset and commercial property a reliable income earner. However, so good has property price appreciation been that property prices have exceeded their long-run expected rate of appreciation of wage inflation (about 4% annually) making property unaffordable. With wage grow likely to stall and the hypnotic trance that property prices rise forever broken, it is logical to expect a pause in property price appreciation – and a continued decline if unemployment rises.

Anaemic portfolio returns ahead?

Putting these all together, it is quite possible that investors might not be able to generate more than middle, single-digit returns over the next five years. For instance, you come up with a figure of 6.4% for a benchmark portfolio of 60% in shares, returning say 8%, and 40% in bonds and cash earning an optimistic 4%. This is a lot less than the average above 9% you would expect for this mix based on 120 years of Australian share and bond market data (Figure 2); putting it at the low end of history and out of whack with the long-term averages some assumptions are made using.

Annualised five-year returns from a portfolio invested 60% in Australian shares and 40% in Australian bonds since 1875.

This is especially sobering when coupled with the fact our starting position isn’t very good either – even despite the last few good months for growth investments. Over the last 10 years Australian index-benchmark multi-asset portfolios earned a below-average 7% annual return, regardless of the percentage of shares and bonds in the mix coincidentally. Over the last five years (albeit unfairly measured to just after the pre-GFC peak) annualised average returns ranged from -1% for a high growth portfolio “rich” in shares to 5% for a conservative portfolio mostly in bonds and cash. To earn a 7% annual return for the 10-year period 2007-2017, growth investors will need to earn at least 13% annually for each of the next five years to make up for earning between 1-2% annually for the last five years. Possible, but not likely.

Problems keeping promises

With these sorts of meagre returns we would face a big problem meeting long-term accumulation and retirement savings plan goals. This problem is shared by both individual and institutional investors, especially the latter in the business of keeping defined benefit promises.

The smartly run UniSuper fund has warned defined benefit plan members that it is considering reducing future payments as “recent investment performance has been lower than predicted” and they have “reduced expectations of future investment returns”. As ASIC is now reminding other fund trustees to follow UniSuper’s lead communicating concerns, this may become more newsworthy. State governments in Australia face substantial pension shortfalls as bond yields fall, reported to be $40 billion across all states.

Contingency planning

I would be quite happy to be wrong worrying about future returns, but if I’m not you may wish you had thought about the following contingencies:

  • Retirees should revisit my earlier prudent spending estimates and perhaps adjust what you can safely spend in retirement (How much is enough). Those derived with a 90% confidence level, assumed 90% of the time you underspent what you could have. These may now be more realistic and a relevant limit. Be careful spending more.
  • If you are or soon will be a beneficiary of a defined benefit fund, then I’m sorry to worry you. I wouldn’t necessarily suggest you don’t take up or stay in that option, just perhaps expect that your benefit or growth in it might one day be trimmed.
  • Accumulators with five to 10 years to retirement should reduce their expectations of accumulating the amounts of funds their group super fund recently has begun to suggest they will enjoy.
  • Conservative (or equity-price volatility intolerant) investors are especially at risk in the medium term as the certainty that bonds and cash returns will underperform is much higher than for shares. These investors need to think about increasing their equity exposure, but only if they promise to stay invested during the next sharemarket collapse and understand this raises their risks of falling short from a mistimed share correction.
  • While highly franked dividend paying stocks represent a logical investment target, with so many chasing them, yields have declined and the risk of lacklustre capital growth or price decline has risen. While maybe greater value is available elsewhere in the sharemarket, these stocks could run for longer as more investors reluctantly embrace share investing.  
  • Inflation-linked bonds, whose fundamental return is linked to consumer price rises, not interest rates, still seem to me a reasonable investment (Inflation-friendly bonds) and deserve a higher mix of your defensive asset allocation (Fortify your portfolio). A warning though: the bond market could devalue these in the short term when interest rates rise.  
  • Be careful chasing higher-yield bond investments taking on increased credit risk or duration – don’t forget that many investment failures in 2007 were in bonds created especially for yield-hungry investors. While I was happy to encourage readers into traditional bonds several years ago, I’m less keen to do so now. Term deposits are still good value and so are annuities linked to inflation in my opinion.
  • Continue to take all steps possible to shelter your money from increasing tax pressures and costs of investing. As governments struggle to fund their pension as well as social spending commitments, your money will be looked at as one way to plug that gap.
  • Don’t forget about surprise inflation and think about investment strategies (inflation investing) that do better than others in that unfriendly environment. A return of inflation will prove my conservative numbers for share and property returns wrong, however, on an inflation-adjusted basis you will be worse off. Of course, if inflation remains low then living with low returns is easier.

It is a real shame that the efforts central banks are taking to stimulate various economies aren’t stimulating investor portfolios – and in fact are doing the opposite. I certainly hope sharemarkets avoid the fate of the Japanese sharemarket, which hasn’t provided any optimism to an entire generation of investors there (Figure 3). I’m less optimistic about the traditional bond market.

Japan’s last two decades of sharemarket returns should remind investors that even a stimulated economy’s sharemarket can go sideways for quite a long time.

As the age of financial repression continues elsewhere and maybe arrives locally, investors will need to adapt to a lower medium-term return environment. I hope I’m wrong and I’m sorry to offer a different view to the current short-term optimism for 2013 (which incidentally I still share!).

Dr Douglas Turek is principal adviser of independently-owned family advice and money management firm Professional Wealth (

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