2016 The Income and Growth Challenge - May 2016
Return Expectations - May 2016
YOU CAN’T ALWAYS EXTRAPOLATE THE RECENT PAST
Over the very long term, South African equities have delivered better returns than any other market in the world (in local currency terms). As is clear from Figure 5, growth assets (local equities, foreign equities and local listed property) have delivered annualised real returns (i.e. in excess of inflation) of around 6% - 7.5%, while income assets (bonds and cash) produced around 1% – 2% real per annum. In the last 10 years, most asset classes (with the exception of local property) delivered real returns that were more in line with their long-term averages than is often the case. This will not be repeated in all planning periods.
The past five or ten years is therefore a poor basis for setting return expectations. It is better to use a combination of very long run returns (see Figure 5) and current valuation levels to set return expectations. We provide our current forecast in Figure 6.
While the headline index values still indicate an expensive local market, most of the more recent market performance resulted from a small number of very large international businesses that happen to be listed on the JSE. Many commodity and domestic counters have sold off significantly, providing current entry prices that have historically been consistent with double-digit returns. This change in share prices supports an increase in average annual expected returns of 1%-2%.
If we look at global equities, valuations are much closer to fair value than they have been a few years ago. The above-average returns achieved over the past five years were partly based on a market rerating. This means that investors are paying more for future earnings, implying lower future returns. It should also be noted that while the slumping rand bolstered returns from these investments over the past five years, this cannot be relied upon year after year. While we continue to believe that global equity is the asset class with the highest return potential over the next several years, the gap between offshore and local assets narrowed significantly.
In turn, income assets are unlikely to deliver significant real returns, given that the sluggish state of the global economy probably means that central banks will have limited scope to tighten the unprecedented ‘easy money’ monetary policies followed in most of the developed world, leading to very low interest payments today and the potential for losses in the great unwinding of tomorrow. We expect local income assets to produce somewhat better returns given the post-‘Nenegate’ sell-off in government bonds and the fact that we are already late in the current interest rate hiking cycle.
Putting all of this together in a portfolio with a risk budget appropriate for income and growth investors, we find that investors should expect annual returns that are 1%-3% lower, on average, than experienced over the most recent decade.