It’s time to diversify to survive new era of modest market gains

 


The ECB still appears likely to increase interest rates in 2019. This is good news for savers but the scope for interest rate rises is much more limited in this cycle given relatively low economic growth rates and high debt levels.
The ECB still appears likely to increase interest rates in 2019. This is good news for savers but the scope for interest rate rises is much more limited in this cycle given relatively low economic growth rates and high debt levels.

Experienced investors have long accepted that past performance is not a reliable guide to future gains. However, if you are investing money for yourself or on someone else’s behalf, you’re probably more interested in a related question: what sort of future performance should I expect now – given how markets have performed in the past?

Bank of Ireland Investment Markets recently updated its long-term return forecasts for the various investment markets. These return forecasts aren’t crystal ball predictions as to what will happen in the short term. Instead, they illustrate the long-term returns we believe investors can realistically achieve if investing today.

The return forecasts assume a long-term relationship between the market valuations investors are willing to pay for investments and the returns which investors should get from those investments.

It’s important to differentiate between market valuations and market prices. Individually, prices or index levels mean little: could a property or stock market investor tell you whether a building or a share is good or bad value based just on its price? No, it’s only when you measure the price relative to what the investment can produce in terms of things like rent, dividends or profits that you can make a judgment on whether good value exists or not.

Looking at long-term valuations across investment markets right now, a few key things particularly stick out. The strong market performance in the post-crisis period pushed up long-term valuations for most conventional asset classes. Consequently, future returns look likely to be more modest than have been generated historically as a result of strong recent performances. Long-term stock market valuations increased as the global economy recovered, but there has been a contrast in how this has played out across the regions and sectors. While the US and technology markets have led, emerging markets have lagged – as have sectors such as energy and materials.

This has produced an overall picture where, in our view, global stock markets are capable of producing long-term returns of around 5.5pc a year – compared to a long-term average of between 6pc and 8pc a year.

The rise in long-term valuations is more visible for government bonds. Government bonds have outperformed for over 20 years, culminating in a situation where $8trn of the global bond market has negative yields – so if you invested and held these bonds to maturity, you would suffer negative returns even before inflation.

Over time, rising yields should boost the long-term outlook for bonds. But for the moment, we believe government bonds are only capable of returning 1.6pc a year over the next 10 years, barely outperforming inflation and much lower than the annual 5pc average return over 20 years.

The ECB still appears likely to increase interest rates in 2019. This is good news for savers but the scope for interest rate rises is much more limited in this cycle given relatively low economic growth rates and high debt levels. Therefore, returns for savers in the next few years will remain low.

In conclusion, rising market valuations have pushed investment returns lower, particularly for conservative investments like cash deposits and bonds. So how can investors overcome this dilemma? A well-diversified portfolio is still the best long-term approach, combining proven inflation-beating assets with innovative alternative investments, such as absolute return funds that could complement bonds.

  • Tom McCabe is global investment strategist at Bank of Ireland Investment Markets
  • Any investment commentary in this column is from the author directly and should not be seen as a recommendation from The Sunday Independent

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