The Economic and Thematic Research team regularly updates its view of long-term investment returns. These are used as the basis for strategic asset allocation by some of Aberdeen’s largest clients and in particular by our diversified multi-asset funds.
The new 2018 edition of the Long-term Investment Outlook widens the coverage of our research to include private assets (private equity, debt, infrastructure, farmland etc.), hedge funds and alternative credit assets like loans and asset backed securities. These are increasingly important for clients in a low bond yield environment.
Long-term economic context
Not much change since last time. The long-term economic context is dominated by marked changes in demographic trends around the world, together with hard questions about the future rate of productivity growth, and the extent to which we face "secular stagnation". Our conclusion is that economic growth will be lower in the future than it was in the decades prior to the financial crisis, but there are reasons for hoping that it won’t be quite as bad as the doomsayers predict.
Our long-term view is that global equity returns, at around 4% p.a., will be weaker than they have been in recent years. Valuations in developed markets are now elevated, particularly in the large US market, and our long-term forecasts are for only sluggish earnings growth. We expect solid growth and low inflation to support equities in the near term, but worry about risks from a slowdown in China or accidents in the exit from QE. Europe remains our favourite region: the business cycle has further to run and profit margins more room for expansion. Though, Trump corporate tax cuts provide a short-term tail wind for US equities.
Bond yields remain near historical lows. Low starting yields make for low long-term bond returns: our 10-year forecasts are just 1-2% per annum. In the short term we expect higher short-dated yields in the US, but we don’t expect as much movement at longer maturities. This is due to low equilibrium real interest rates. These are held down by slow-moving demographic forces, which we think will persist for several more years.
The dollar remains expensive on a trade-weighted basis, using standard equilibrium exchange rate models. We expect the gap in interest rates between the US and other developed-market economies to maintain this strength in the near term, but over the long term we expect negative currency returns for overseas investors in US assets. EUR has strengthened this year, but GBP and JPY are both cheap on an equilibrium exchange rate basis. We expect them to strengthen in the long term. Sterling’s fate in the near term is heavily linked to the eventual form of Brexit.
The US credit cycle is now mature. Yet US credit spreads are still tight, offering a small premium for bearing credit risk. In addition, the (gently) rising government-bond yields we expect will erode returns, particularly for longer-duration investment-grade bonds. Our returns forecasts are modest (around 2% US investment grade, 3.3% high yield, with even lower forecasts for European equivalents.
We expect higher risk-adjusted returns from less familiar forms of credit. Corporate loans are typically floating rate, so are not exposed to the risk of rising interest rates. Asset-backed securities (ABS) also offer attractions compared to conventional corporate credit. Like loans, they benefit from floating rates, but they also typically have wider spreads for the same credit quality. At the mezzanine level, BB-rated ABS spreads are 2% higher than BB-rated HY bonds. This boost to returns is compensation for the greater complexity and more limited liquidity in this sector.
Emerging Market Debt (EMD)
Emerging-market government bonds are a relatively attractive asset class – particularly the local currency variety. Yields are high (6%) relative to developed markets, offering strong income return. With one or two exceptions, the emerging-market economies covered by the standard EMD local currency index are in good shape with solid growth, controlled inflation and low government-debt levels.
Property and Real assets
The high yields on offer from these assets have made them very attractive to investors in a low bond yield environment. Strong demand has compressed risk premia, although expected returns remain competitive. Property return expectations are depressed by Brexit in the UK, but reasonable elsewhere, driven by robust rental income growth. Listed social and renewable infrastructure assets continue to offer attractive returns from income, although capital growth will be limited. Real assets continue to offer useful diversification from equities, particularly in the case of infrastructure and farmland
History shows that private equity delivers a substantial illiquidity premium for investors. Its size varies over time, but over the most recent complete decade, the US PE illiquidity premium has averaged 4%. Today, ‘dry powder’ and purchase price multiples are high, so returns for new funds will likely be at the low end of the scale, but significantly ahead of public equities nonetheless. Returns are extremely varied between managers, so good manager selection is a key factor.
Hedge Funds and Alternative Risk Premia
When considered as an excess return over cash, we expect these strategies to deliver a worthwhile return net of fees. Many hedge-fund strategies can also offer valuable diversification from traditional markets. As with PE, there is a large dispersion of manager returns, so careful manager selection is vital to returns.
Asset allocation overview
Low expected returns for government bonds means that the traditional ‘balanced’ equity-bond model is no longer the best option for many investors. Our multi-asset portfolios increasingly look to diversify their equity exposure by allocating, instead, to EM debt, asset backed securities, infrastructure and various other liquid alternatives. As the Forecaster chart shows, these assets offer much higher returns than government bonds, but with lower risk than equities. They also have low correlations with each other, allowing for more diversified portfolios.
The full Long-term Investment Outlook report can be accessed here.