SHOULD YOU PREPARE FOR LOWER RETURNS?
Mark Lister, 15 March 2018
Forecasting returns for shares and fixed income isn’t easy. It’s even harder when people don’t like the answer you give them.
The returns from shares come from the change in price, plus the dividends you receive along the way. Dividends are somewhat predictable, provided you build in some conservatism for the inevitable economic slowdowns. Predicting share prices is harder, although a key determinant of where they will go in future is your starting point.
In 2009 and 2010 when markets were highly pessimistic, the chance of the coming years treating you well was reasonable. Today, prices are at records and optimism is high.
Nobody can accurately pick the top or bottom of the cycle, but I can tell you we’re closer to the former than the latter.
For fixed income, you get your regular income and then your capital returned. Prices for securities move up and down depending on the prevailing backdrop, but for those who are holding until maturity, that’s less relevant. Your return is simply the income you receive.
Our interest rates peaked in 1985 at almost 20 per cent, then fell consistently for three decades before hitting historic lows in 2016. Today, they’re still only barely above that.
Fixed income investors can expect little more than four per cent if interest rates remain at current levels. If they rise, capital values will decline. For most that’s only a paper loss, and at least reinvestment rates would’ve improved. As long as your maturities are laddered, you’ll be fine.
With all of that in mind, it’s fair to say return forecasts for the next few years are looking pretty ordinary. That can be difficult for some investors to get their head around, particularly newer ones who’ve only experienced this recent golden period.
NZ shares have returned 14.0 per cent annually over the past seven years, including dividends. That’s a hugely impressive run, especially considering the inflation rate since then has been just 1.2 per cent.
In the last fifty years NZ shares have returned 9.9 per cent, still ahead of the 6.0 per cent inflation rate, but to a much lesser degree.
If you take that historic premium, and you think inflation will be 2-3 per cent over the coming several years, you can deduct your shares might do about 6-7 per cent. Combine that with four per cent from fixed income, and you’re looking at low-to-mid fives for a diversified portfolio. Give or take.
Anyone who promises substantially more than that is either highly optimistic regarding growth, inflation and corporate profitability, or is leading you up the garden path. Maybe they’re lazily assuming the next five years will look like the last five, in which case I’d be extremely wary.
A combination of high valuations, low (but rising) interest rates and below average dividend yields means returns will be uninspiring. Property is in exactly the same boat, suffering similarly from stretched valuations.
This won’t be the case forever, of course. Interest rates will rise, reality will catch up with overheated valuations and normal service will resume. How that occurs is impossible to predict. It could mean a few years of below average returns, or we could get a quicker, sharper decline that provides a reset.