Does our approach work?
It takes ten years to determine if a ten-year forecast is successful. Since Barings began these forecasts in 2003, results from the early forecasts are finally coming back.
We have compared our 2003 and 2004 forecasts with actual market returns, and the results are very positive. The results of the 2004 vintage forecasts are shown in Figure 1.
For example, in 2004 Barings forecast emerging market equities to deliver the highest returns, at just over 10% annually. As it happened, emerging equities returned 10.3%. We forecast Japanese equities to perform the worst of all the major markets. Property was also expected to outperform bonds. All of these predictions have been broadly correct.
Not everything went our way. The two most glaring errors are for inflation-linked bonds and cash rates. In 2004 we did not expect cash rates to go to near zero, nor for UK inflation to jump up sharply between 2009 and 2011. Both of these errors are related to the extreme impact of the 2008 crisis. Our expected bond returns were also too low – an error related to the zero cash rates currently seen around the world.
Nevertheless, these results show that the major trends in the markets were accurately captured. Our results from the last ten years reassure us that taking such a long-term view is indeed a useful discipline.
What does our approach say for the next ten years?
We expect that over the next ten years, economic growth will moderate at best. It is unlikely, for example, that the US will be able to grow anything near as fast as the 4% annual GDP growth rate it was able to record every few quarters only ten years ago.
The developed world in particular faces a number of challenges. Demographics will continue to be a drag on growth, as developed market populations age. Productivity growth is also slowing in a number of advanced economies, while credit regulation, a major consequence of the global financial crisis, will constrain investment. For example, our work establishes the trend rate of growth for the US and UK at just 2.3% and 2.2%, respectively.
These forecasts are modest in comparison to the consensus. But to us it is no surprise that institutions such as the International Monetary Fund and the US Federal Reserve have consistently overestimated potential growth. They have yet to embrace the magnitude of the secular changes taking place.
We are also likely to be living with the consequences of extraordinary central bank action for a long time to come. Financial repression, where savers are squeezed at the expense of borrowers through low interest rates, has driven global bond markets since the crisis. It is not the first time financial repression has been used – even more extreme techniques were used after World War II. But these other experiences show how long financial repression will remain with us.
Consequently, our ten-year forecast sees cash rates and bond yields remaining lower for longer. We expect the sterling cash rate in 2025 to be just 2.5%, with ten-year Gilts yielding only 3.7%. With little to fear from the government bond market, credit markets do well. Increased bank regulation will likely constrain credit provision over the next
Source: Barings as at 30 April 2015. *Risk = standard deviation of annualised returns.
several years, and this lack of competition from banks should mean that credit investors will see decent returns.
Based on our analysis, we expect equities will perform fairly well over the next decade. Growing dividend yields should prove attractive in a yield-starved world, and while valuations are already high today, it is possible they will be pushed even higher.
In particular, we believe that UK, Japanese and (to a lesser extent, given the increase in risk) emerging market equities should provide the best investment opportunity over the next decade. The US, having performed very strongly over the past several years, is likely to fare more modestly over the same time horizon. With profit margins already at cyclical highs, US companies may see mild margin erosion as interest rates rise.
On the other hand, our analysis suggests that the dividend yields available in the UK are the highest of any major region, which should drive equity prices.
In Japan, we expect the effects of Abenomics to materialise over the next few years, which should allow corporate profitability to catch up with other regions. Japan won’t become a shareholder-driven market overnight, but if it could close the gap with the culture in Europe this would still mark a big turnaround in profitability.
Emerging market equities have fallen to relatively inexpensive levels and still benefit from favourable longer term trends, such as good demographic profiles in many emerging countries. However, poor corporate governance does mean equity holders are likely to suffer more dilution of returns over the decade, and thus we expect only a very modest premium for investors in the asset class over markets like the UK and Japan.
On currencies, the weakness of sterling over the last year has largely corrected our longstanding view of sterling overvaluation. We do not anticipate any large currency moves over the next ten years. Nevertheless, sterling is still (mildly) one of the more expensive currencies and we expect it will fall modestly in value against both the US dollar and the euro. Such a fall would mean that holdings in overseas assets benefit UK-based investors.
Looking ten years ahead
Our approach to long-term forecasting considers secular trends such as productivity, demographics and the availability of credit.
We look at previous episodes of financial repression to determine how long the current state of affairs might last. We quantify these forces, which are then combined with current market valuations to see how each asset class is likely to fare over the next decade. In this analysis, we have calculated the expected returns in sterling.
The benefit of this approach is that it allows the total returns of each asset class to be compared across markets using a consistent set of assumptions.
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