Why the best case scenario is lower returns

In April 1992, Australian Government Bonds yielded over 13.5%. The annualised inflation reading for the March quarter of that year was 8.7%. It had been well north of 5% for most of the previous 20 years and, given 13% government bond yields, there was an expectation that it would stay that way.

Fast forward 25 years and the world couldn't look more different. In April 2015, the same 10-year bond yielded 2.5%. Despite interest rates approaching zero, inflation expectations have fallen dramatically.

This unexpected contraction in inflation and interest rates has been a bonanza for investors in long-dated assets like shares, property and bonds with distant maturities for three principal reasons.

First, because inflation has been lower than expected, the 'real' income return from these assets has been higher than expected. The 13.5% nominal return on the 1992 government bond, for example, might have assumed a real required return of 3.5% and inflation of 10%. If actual inflation ends up being only 5%, the investor's real return is 8.5%.

Second, investors have experienced dramatic capital gains as the required return on assets has fallen. Investors that required 10% yields on rental properties in 1992 might only require 5% today in order to achieve the same expected real return. All other things being equal, that allows them to bid prices up to double the level of 1992.

More debt has pushed up asset prices

Third, and related to the second point, low inflation means low interest rates and low interest rates mean investors can borrow more money, without increasing the cost of servicing that debt. In 1992 the ratio of debt to disposable income was 50%. Today it is 150%. Yet the percentage of disposable income dedicated to servicing that debt has only increased from 6.4% to 8.9%. More debt means people can pay higher prices for assets.

What does this mean for today's investor looking for long term returns?

Some believe the low interest rate environment has been manufactured by central banks, creating one giant asset price bubble that could burst at any moment. Others suggest that ageing populations and an excess of savings over investment mean that low inflation and low interest rates are here to stay.

Irrespective of your view (I have some sympathy for both arguments), one thing is clear. What happened in the past 25 years isn't going to happen again.

Don't get me wrong. Interest rates in Australia can fall further. The return on Swiss 10-year bonds is negative. Mexico recently issued a one-hundred-year bond (in Euros) that yields just 4.2%. This is the same Mexico that, according to The Economist, has had eight episodes of default in the past 200 years.

Even if interest rates do fall from 2% to almost zero the effect is going to be nothing like the drop from 13% to 2%. Whether we are at the end of the end or the beginning of the end, we are clearly at the end. The 25-year bull market in all asset classes, driven by a dramatic fall in interest rates, is not going to be repeated.

The next question is whether it will be reversed. No one knows the answer to that but the risk is mostly to the downside. If the world is able to sustain the current trajectory of low growth and low inflation for a long time, then today's asset prices are about right. Given interest rates can't fall much further, that's about as good as it gets.

If the inflation genie escapes the bottle we'll see at least a partial reversal of the gains of the past quarter century. It's impossible to say how likely this is but I do believe we are living through a period that historians will come to see as a watershed moment for the global financial system.

Perhaps it will still be referenced as the financial crisis of 2009, or the Great Quantitative Easing of 2009-2015. However it's remembered, I believe it will come to be seen in the same way as the Bretton Woods agreement of 1952 and the abandonment of the gold standard in 1972, as a period that shaped the financial system forever.

Equities remain attractive

There will be consequences, and both rampant inflation and entrenched deflation are surely on the list of possibilities. But what does it mean for sharemarket investors?

It's important to recognise that low inflation has impacted all asset classes, so you can't simply switch between them. As I've pointed out before, equities remain relatively attractive for the long term investor.

Within a share portfolio, I would avoid stocks caught up in the headlong rush for yield that has driven some share prices to unsustainable levels over the past 12 months. Equities are not bonds. Returns come from capital appreciation and yield and, at the moment, opportunities in shares that offer more of the former are far more prevalent.

I would also avoid lowering your standards in pursuit of higher prospective returns. Lower quality businesses can look particularly appealing in markets where everything else seems expensive. If a correction does ensue, however, these are often the businesses that perform the worst. Often they do not survive.

My grandmother once told me that the secret to happiness is low expectations. Perhaps the secret for today's investor is the same. Don't change your strategy. Just lower your expectations.

Steve Johnson is Chief Investment Officer at Forager Funds Management (formerly Intelligent Investor Funds). You can find out more about Forager Funds by downloading a company brochure and PDS here.