27/06/06
Asset returns in a low inflation world
Headline inflation rates have been picking up, reflecting the major turnaround in the global economy since 2001. This has spurred one particular component of inflation, commodity prices, to move higher, with the oil price, for example, at record levels. Nevertheless, these inflation pressures look rather transitory. As economies become more dominated by service sectors, commodities become a smaller input for businesses. There is still plentiful slack in global labour markets to keep wages subdued. Finally, global competition, not only in goods but also in services, is keeping pricing power under control. All in all despite the pick-up in headline inflation recently, financial markets are signalling high levels of confidence that the inflation targets for central banks will be achieved.
With these forces seemingly entrenched, we consider how investors should achieve the best returns in a low inflation world. What does an environment where prices change quite slowly mean for asset returns and how might these returns be enhanced? One issue investors need to be aware of is the distinction between nominal and real (inflation adjusted) asset returns. Many investors can be susceptible to what is called money illusion whereby they fail to take into account the impact that inflation can have on historical or projected asset returns.
Chart 1 shows how inflation has influenced historic returns achieved from a range of UK assets during various periods in the past, but also how investors' return expectations may be influenced by different historical experiences. If investors were looking back over the three years to May 2006 (a recent peak in the equity market) they would have achieved a 22% annualised total return, or 19% after taking inflation into account. Property investors also enjoyed strong returns of 18% a year, or 15% after inflation. For gilt and cash investors returns were closer to 4.5% in nominal terms and 1.5% in real terms.
Of course, if inflation remains low, most investors would be sceptical that such strong equity and property returns are achievable. This is because the recent period for equities has been unusually sanguine: a rebound after the worst bear market for a generation, strong corporate earnings growth and lower than average interest rates. Property returns for investors have been boosted by similar drivers, as well as the belief that this asset offers a sustainable, uncorrelated portfolio bet and inflation beating characteristics.
An alternative time period to examine market performance would be the 1990s global business cycle. Over this period, UK equity returns were also strong, while gilts benefited from falls in both actual inflation as well as inflation expectations. Interestingly, property returns were weak early in the decade, so the performance over the whole period at only 8% a year was rather lower than investors have recently been used to. One driver of asset returns in the 1990s which we doubt will be repeated was dis-inflation, in other words falling inflation, which over the decade fell from 9.5% to 1.5% a year. This caused certain assets to re-rate strongly, especially government gilts.
It is worthwhile therefore to examine the very long term, which can smooth out the effects of cycles in business activity or inflation rates. We can compare market returns since 1900; the average annual nominal return for equities, gilts and cash, was 11.5%, 6.0% and 5.1%, respectively. Inflation accounted for 4.2% of this performance across the twentieth century.
Given this history, let us look forwards. What returns can investors reasonably expect over the next few decades if inflation remains low and stable? The inflation regime is important for determining asset returns. Generally, assets whose returns are fixed in nominal terms, such as conventional government or corporate bonds, do not compensate investors for inflation as the coupon is fixed. Conversely, equities are seen as ‘real' assets in the long run, since dividends can eventually adjust upwards with earnings growth, and in line with inflation. In the past, rents from commercial property have also been able to grow close to inflation over periods of time.
It is possible to assess likely asset returns over the next 20 years in the UK. We have used a sum-of-the-parts approach to come up with a central projection for nominal and inflation adjusted returns for each asset class (see chart 2 ). In order to simplify what would otherwise become a rather complicated piece of analysis, we have made a deliberate assumption that there will be no re-rating or de-rating of assets.
Starting with equities, returns are assumed to be made up of the achieved dividend yield, plus likely dividend growth. Historically, dividends have accounted for the majority of total returns available from equities, despite their reduced importance in recent decades. On this basis, average annual equity returns are projected to be 7.5% over the coming 20 years.
Property total returns are expected to be 6%, taking account of the initial yield as well as some real rental growth. An allowance has to be made for certain costs, such as depreciation, which do matter over a property investment lasting 20 years.
For gilts and cash, the current yields of around 4.7% are assumed to be fixed in a steady state inflation world, suggesting returns at these levels. Corporate bonds should have only slightly higher returns than gilts as spreads are historically tight.
These central scenarios suggest equities will continue to outperform other asset classes. However, over a two decade long period, the range of returns around these central forecasts could be large, especially for equities and property. The business cycle will intervene, creating market volatility. For these reasons, it is strongly suggested that a number of assets with different return and volatility characteristics are needed to construct an optimal portfolio.
The discussion so far has concentrated on the likely central returns scenario for UK assets. Some investors may be concerned that UK equities, in particular, are overly exposed to the UK economy. This has performed poorly relative to other parts of the world, including the US and parts of Asia, in recent years. Other investors have cited the UK's over reliance on the sluggish housing market and consumer spending for future growth. However, the domestic influences of housing and consumer spending only have a small weighting in the stock market. The housing sector, for example, is around 2% of the FTSE All Share, while consumer goods make up 9% of that index and general retailers 3%.
What is more important for the outlook for UK equities is the performance of overseas economies. Close to 55% of UK equity market sales come from overseas. Fortunately for equity investors, the world economy is likely to continue the strong growth path seen in recent years – with GDP growth likely to be in the 5-6% range, when the like of India and China are included. Also despite the prospect of slower growth in the US, recent communications by the Federal Reserve suggests that the chance of a serious policy mistake with monetary policy, causing a recession, for example, are quite limited. In any case companies remain upbeat – S&P500 earnings growth for Q2 should be in the 11-13% range, the US labour market remains flexible and underlying inflation under control.
To sum up, our analysis suggests that there are powerful drivers that will keep inflation low and stable over the foreseeable future. Consequently, we can project likely asset returns over the next 20 years. These suggest equities should be favoured as they better compensate investors for inflation. However, the out-performance over other assets will be more moderate than it has been in the past. The difference in performance between asset classes will also be narrower as the structural fall in inflation and interest rates that have been key drivers of market returns in recent decades comes to an end. In addition, the greater volatility typically surrounding equity assets compared to bonds, for example, suggests that investors should construct a diversified multi-asset portfolio as part of their strategy.
Richard Batty, Global Investment Strategist, Standard Life Investments
First published in Financial Adviser on 27 July 2006
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