What return expectations suggest for future investor returns.

As global economies recover from coronavirus-inspired disruption and central banks shift their mindset to combating inflation pressures, it feels as though we’ve reached an inflection point in financial markets. Following the global financial crisis, a combination of declining interest rates and favourable policy settings has benefited multisector investors whose portfolios contained a mix of stocks and bonds. In the current environment of seemingly high equity valuations, one could be excused for thinking a change in sentiment has reduced return expectations across most asset classes. We decided to investigate this assumption with our multisector managers and identify the prospects for investors going forward.

Each multisector cycle we ask managers to provide their capital market expectations (return and standard deviation across multiple asset classes) with a timeframe of five years or more. This timeframe is chosen to capture long-term numbers which are relevant to “strategic asset allocation”-based strategies, while also capturing shorter- to medium-term data which would be relevant to “objective based” approaches. Multisector investment managers are best placed to provide such information as they invest across all asset classes. These managers consider the relativities of return and risk across all investable choices prior to allocating capital.

The outcomes of this survey were enlightening, outlining some clear trends in thinking along with areas where expectations diverged. Exhibits 1 and 2 display the data collected; each larger blue dot represents one fund manager’s expectation of more than five years, while the smaller black dot is the average expectation from all managers. Asset classes are grouped from least risky to most risky from left to right.

Let’s start with returns. Notwithstanding early 2020’s market turmoil, investors have experienced strong long-term returns from both the growth and defensive sides of their portfolios. Defensive exposures such as fixed income have benefited post-2008 against a backdrop of quantitative easing, a trend that’s pushed long-term bond yields to all-time lows. However, bond markets are indicating it’s one that is beginning to reverse, as yields have risen on inflation expectations and anticipation of higher interest rates. At the same time, these historically low bond yields made growth assets such as equities comparably more attractive, supporting the rally in assets prices. For multisector investors in a balanced 50% growth/50% defensive portfolio similar to Morningstar’s multisector benchmark, the annual return of 8.2% over 10 years to 31 Oct 2021 is a fruitful outcome, as spelled out in Exhibit 3 below. After such a strong return environment, where to from here?

Defensive Assets

First looking at defensive assets, an interesting observation from this data is the return and risk assumptions of the risk-free rate—cash which has broader investment implications. From Exhibit 1 we can see the average manager expects a medium-term cash rate just below 2%. Given the Australian target cash rate remained unchanged at 10 basis points from the Reserve Bank of Australia’s most recent November meeting, and the equivalent rate in the US at 25 basis points, consensus suggests the path of cash rates will be on a materially higher trajectory. Although, bear in mind that these numbers represent the forward expectations from managers over five-plus years. The most hawkish manager sees the cash rate at 4% over this timeframe. The prospect of higher rates will have impacts across other asset classes, bonds in particular.

The bond return data in Exhibit 1 indicates average expectations for Australian and Global Bonds is similar, around 2%. Of note, this return is not too much higher than current 10-year yields. In late October, the Australian 10-year stood at around 1.8% and the US at 1.6%. We can glean from this is that while the environment is forecast to be higher-yielding, expected rises in yields are likely to restrict total returns from bonds. The term premium expectations are also very low when viewed relative to cash expectations.

Exhibit 2 shows the risk expectations from managers of more than five years. When we look closely at Exhibit 2, we can see the average manager expects annualised volatility of Australian and Global Bonds to be approximately 4%. This means that managers expect a one standard deviation event (or put another way, see a 68% probability) of return outcomes between 6% (mean of 2% plus the standard deviation of 4%) to negative 2% (mean of 2% minus the standard deviation of 4%) for investors. In short, negative returns from bonds are a real possibility over the medium term.

For investment-grade credit, on average managers expect a 2.7% return from Australian and global names. This implies a credit risk premium of around 70 basis points, which is on the tighter side relative to history. In addition to this, return expectations for high yield or sub-investment-grade are moderately higher than investment-grade credit, as a 3.9% average implies a risk premium over government bonds closer to 2.0%. Interestingly, the average expected volatility for Australian credit is broadly similar to bonds, yet global credit is over 1% higher than its bond equivalent, while the forecast volatility in high yield is significantly higher again. With credit spreads at lower levels, this suggests managers have expectations of reduced compensation for taking credit risk and face higher risks, particularly for those investing in offshore securities.

Growth Assets

Moving to growth assets, expected returns for Australian REITs are on average slightly higher than their global counterparts, but the variance in expectations is much wider for the latter. The most bullish forecast is 9%, while the bear case is nearly as low as 3%. Both markets have a similar standard deviation profile in the mid-teens. Sectors such as real estate, infrastructure, and utilities can act as proxies for the bond market, making them susceptible to interest-rate rises and price falls as investors have increasing alternatives when looking for income.

With regards to equities, the return data suggests the expectations of Australian and global equities are marginally higher for the domestic market at 6.4%, compared with 5.8% unhedged and 5.6% hedged. The benefits of franking credits attached to domestic equities likely influence this differential. But at the same time, the Australian share market has lagged the MSCI World ex-Australia index the past decade, indicating there may be better value locally when comparing current valuations. Also, potentially higher interest rates must be incorporated into discounted cash flow models when valuing equity securities. This change in input is more adverse for sectors such as technology, which comprises a higher portion of the US share market compared with the domestic one, as well as other stocks with high price/earnings multiples and long-duration cash flows.

The risk data suggests managers expect higher levels of volatility from the domestic equity market relative to global, aligning with the risk-return trade-off and stronger return expectations. The average equities return expectation is around cash + 3.5%-4.5%; this is at the lower end of the long-term equity risk premium and equity valuations could be considered stretched. It is also possibly a reflection that a prolonged period of loose policy settings pushing equity markets to record highs following the financial crisis, may be about to change.

While this Australian and global equity return data is interesting, it contrasts with the typical bias within equities. Where the mandate allows, Morningstar’s surveyed asset allocation data indicates managers have maintained an overweight exposure to global assets in recent years. Even the benefits of a higher yield and franking credits has not dampened the desire for global equity assets. Reasons for this allocation could be higher growth forecasts for global economies relative to Australia or the preference to hold markets which have reduced concentration in sectors and stocks.

Looking at the average emerging market return, managers believe that expectations will be marginally greater than Australian and global equities, but also with about one fourth of the extra volatility. This is consistent with common perception that there is adequate compensation to warrant a manager investing in emerging-markets securities, however, it comes with additional risks to developed markets. This is perhaps also a reflection of concerns around slowing growth in China’s economy, as the nation represents about one third of the benchmark’s geographic allocation.

Putting it All Together

Taking a step back from asset-class-specific discussions, there is one overarching theme from the survey data: Return expectations are much lower. Using the asset mix from Morningstar’s Balanced Target Allocation benchmark and the average return expectation for each asset class, the total forecast return is 4.0% over the medium term, as set out in Exhibit 4 below. The last time we ran this exercise in the Multisector Sector Wrap—October 2017, return expectations at the time pointed to forecast return of around 5.5%. What eventuated was markedly better than anticipated when compared with the previously mentioned annual return of 8.2% which investors have enjoyed the past decade, a figure that is materially less on a going-forward basis, though.

One key point here is that these numbers are not a static data set—managers review these expectations every quarter to every year. These numbers can and do change depending on the expected market regime. But if these decreasing expectations come to play out, then investors need to brace for lower returns. A common disclaimer is past performance is not a reliable indicator of future performance; it appears multisector investors might be about to live this assertion.

Written by Morningstar, Chris Tate, Manager Research Analyst, 24 November 2021