11 Mar February Market Commentary
We have shown below the specific forecasts for the United States and Europe under Developed Markets, demonstrating the divergent outlook between those two markets which is masked by the blended 6.5% overall forecast shown. Relativities between asset classes remain intact since we last wrote to you.
10 Year Forecast Returns
|Inter Eq – Dev Mkts
|Inter Eq – Emerg Mkts
|5 Yr TD
|+ EPS Growth (’15 – ’25)
|+ Valuation Effect
|Index Return (Pre-tax)
Ahead of the updated forecasts and comments on each of the asset classes that will follow, we will revisit several of the elements that comprise our long term expected returns. In most investment markets around the world one of the principal influences is still the actions of the central bank, and hard as it may be to recall that wasn’t always the case. There was a time that changes in interest rates were more just a tap on the brakes when an economy was getting overheated, or conversely a tap on the accelerator when an economy needed some encouragement. By manipulating the price of money the central bank was able to influence the trajectory of the economy with the objective being to smooth the cycles between peaks and troughs, or booms and recessions. It was then and remains now an imperfect science, which is why monetary policy is often referred to as a blunt instrument.
As we compose this note in the first days of March we know now that the RBA has chosen to keep interest rates at 2.25% following the cut agreed at their first meeting for 2015 held in February. The following day we also gained a further insight into the trajectory of the Australian economy with GDP growing at 2.5% year on year. This is consistent with the language that we have heard in statements from the RBA, to the effect that the economy is expected to continue to grow at below trend growth rates, but continue to grow nonetheless. One consequence of that sub trend rate of growth is that the unemployment rate is expected to peak at a slightly higher rate than had previously been forecast.
Of course Australia is part of the global economy, and so in addition to judging an appropriate monetary policy stance based on where we are in the economic cycle, the RBA needs also to assess external influences over which it has no control. In recent times the economies of many major developed nations have faced far greater struggles than has Australia, such that a tap on the accelerator was not enough to garner a response in an economy like the United States which was attempting to extricate itself from the financial crisis. This led to unconventional monetary policy that sought to further stimulate an economy when cutting rates to zero had been shown to be insufficient. We now see that Europe and the European Central Bank are embarking on that same extraordinary policy course.
All of which begs the question, what does this mean for our long term asset class forecasts? The view of the Asset Allocation & Investment Committee is that interest rates are likely to stay lower for longer, and very likely much lower for much longer than many had recently expected. Official interest rates such as the Cash Rate set by the RBA are a benchmark from which other investments are priced, with the actual rate of income return set by the market based on an assessment of the additional risk accepted by the investor. One of the key aspects of the valuation bands in the above Asset Class Valuations chart is the threshold between Fully Priced and Overpriced, for which we use the return available on a 5 year term deposit from a major Australian bank, as it represents a readily available risk free return. As the RBA cuts rates, so the returns on term deposits generally fall commensurately, and the forecast returns for the more desirable valuation bands also fall. The green bands which are the Cheap valuations start where our forecast is to receive better than 5% pa over the risk free rate, so if risk free is 5% then Cheap starts at 10%, however if the risk free return falls to 3% Cheap now starts at 8%.
A similar phenomenon, though not in these exact terms, has been a strong source of support for the US Equities market in recent years. In that market risk free has meant essentially no return for many years now, with rates on 10 year investments similar to term deposits being just 0.15%. That is, foregoing access to your funds of at least $100,000 for a decade would provide a return of $150 each year. It is little wonder therefore that investors have sought returns elsewhere and this demand for shares has bid up their prices to a valuation that we think portends poor future returns.
There is an additional element to lower interest rates that also influences our forecasts. The chart to your right shows the relationship between inflation and the valuation measure we use the Price / Earnings or PE ratio. When inflation is contained the RBA is able to keep interest rates low, and we are confident that that is the case now and is likely to remain so for some time. The relationship shown in the chart implies that low inflation and interest rates are able to sustain higher valuation multiples, or PE ratios towards the top of the red box rather than the middle or lower ranges shown.
If we are therefore heading for a higher valuation towards the end of our ten year forecast period, then the expected average annual returns increase along the way, and it is that kind of environment which we believe will persist for longer than had previously been the case. The three elements of our long term forecast are: Income + Earnings Growth + Valuation Changes = Expected Returns. Tax advantaged income generated on Australian Equities will become relatively more attractive as returns on traditional safe or defensive investments fall, core earnings growth is relatively modest but will pick up as economic growth returns to trend and higher valuations are likely supported by lower interest rates.
The return on Australian Equities has come down since our last quarterly commentary, reflecting the strong recent performance of the asset class. We are being conservative about moving up the target PEs at this stage. This allows some upside to the forecast return stated above when we incorporate revised figures.
The currency has stabilised in recent times, though if further rate cuts are forthcoming then the RBA will see the A$ head towards what they believe is fair value, and this will provide further support for international exposure. Our views here are largely unchanged; we see poor long term returns for the United States though parts of Europe look much better and remain under consideration.
Gearing ratios within Listed Property are a key risk metric that we follow for this asset class and pleasingly they remain within acceptable ranges. At the same time an increase in payout ratio that supports the income from these investments have also been maintained. In a lower interest rate environment we think the yield on offer will look more attractive.
CASH AND TERM DEPOSITS
Due to movements in February by the Reserve Bank to reduce cash rates to 2.25%, returns on cash are approaching zero in real terms (that is, after you take inflation into account). This move has also had a significant impact on the short and long term deposit rates. We have seen the five year rates drop to around 3% to 3.2%, whilst you will be strapped to find one year term deposits paying better than 3% (more like 2.9% as of today). This shows us that the banks aren’t expecting much of an uplift in rates over the long term.
DISCLAIMER: The information in this commentary has been provided for publication by Implemented Portfolios (ABN 36 141 881 147. AFSL Number 345143). The information has not been verified by Implemented Portfolios or Adapt Wealth Management Pty Ltd (ABN 76 821 231 362 Corporate Authorised Representative of Paragem Pty Ltd AFSL 297276) but is believed to have come from reliable sources as noted in the acknowledgements. No Liability is accepted by Implemented Portfolios, or Adapt Wealth Management Pty Ltd, its Directors, officers, employees or contractors for any inaccurate or incorrect information. The information is a broad commentary and there is no intention that a client should act on the information without seeking professional assistance from their own advisers (legal, tax, accounting, financial planning) for suitability in respect of their unique circumstances.
About Reuben Zelwer
Reuben Zelwer established Adapt Wealth Management in 2011 to help time poor clients achieve financial freedom. For over 15 years, Reuben has helped professionals, executives, business owner and those approaching retirement make the most of their circumstances by making good financial decisions. Reuben’s professional practice is complemented by substantial voluntary work, which has included setting up financial literacy and savings programs in the local community.