The world economy will strengthen over the next five years, but the average investment returns won’t.
“Nevertheless financial markets still offer investors enough opportunities to make money”, Robeco’s Artino Janssen says.
Returning to normality
These are the key predictions in Robeco’s latest five-year outlook, which aims to advise institutional investors on what to expect from now until 2018.
It is now five years since the financial crisis brought turbulent markets, bank bailouts, recession and austerity. The next five years should not be as dramatic - but what should investors expect?
First, the good news. “In our baseline scenario for the next five years, we expect a generally strengthening of the world economy,” says Janssen, Executive Vice President for Investment Solutions & Research.
“We see inflationary risks, but we doubt whether they will come through significantly, and whether that would be within five years.” Inflation was not significantly impacted by trillion-dollar quantitative easing (QE) programs, and is expected to remain below 2% once they begin to unravel.
"We expect a strengthening of the world economy"
The end of easy money
The end of QE will also signal the end of easy money, as market interest rates – and eventually, official base rates – begin to rise from their currently historically low levels.
“We expect 10-year bonds yields to rise gradually in the years ahead, with a 10-year German bund yield of around 3% at the end of 2018, a bit ahead of the forward curve,” says Janssen, co-author of Expected Returns, 2014-2018.
As yields rise however, bond values (which move inversely to yields) will fall, reducing overall returns for fixed income investors. The five-year outlook predicts an overall average annual return of about 0.5% for high-quality government bonds, below the expected rates of inflation, which would imply negative real returns for the first time since the financial crisis.
Corporate and high-yield bonds, along with emerging market debt, are more attractive because of their risk premium over government bonds, as the table below shows.
Stocks also impacted by higher rates
The picture is different for stocks, where Robeco sees higher average returns of 6.75% over the next five years. Global equities have had a good run so far this year and are currently slightly overvalued by 13-15% depending on which indicator you use, Janssen says. As with fixed income, higher returns are available in emerging markets, but with higher risk.
“Over the last 30 years all asset classes, including equities, have benefited from the strong tailwind of declining bond yields. This year we have seen this tailwind turn into a mild headwind,” he says.
“Further multiples expansion for equities will be difficult in an environment where central banks firstly reduce QE, followed by the gradual disappearance of artificially low interest rates. Earnings growth will be the key driver but further expansion of profit margins will be difficult.”
“Further multiples expansion for equities will be difficult”
Real estate and shale gas overblown
Other assets popular with investors include real estate and commodities, with huge interest in the consequences of the US shale gas revolution – but Janssen feels both sectors are currently overblown.
“We believe global real estate to be overvalued compared to stocks. The current valuation is likely to generate a headwind in the next couple of years as real estate tends to be more interest rate-sensitive than equities,” he says.
“And although the impact of the shale gas revolution will eventually be felt across regions and energy markets, we hold the view that for the next five years, shale gas will remain a largely US phenomenon.”
Lower portfolio returns on balance
While we expect lower average investment returns for 2014 -2018, financial markets still offer investors enough opportunities to make money, Janssen says. This can be achieved by deviating from the traditional market portfolio in which government bonds have a high weight, by allocating to asset classes that offer attractive risk premiums, such as equities or high yield.
“On balance, we expect returns that are below our prior long-term estimates for 2013-2017, though we believe risk premiums relative to safer assets remain very attractive over the next five years,” he says.
The table below shows how Robeco’s Expected Returns this year compare with the forecasts of the previous year’s report.