When it comes to investment strategies, we are all aware that past performance is no guide to future returns. But it's easy to forget that the same applies to asset classes. Most of us have rules of thumb as to the typical returns that particular markets provide. But we need to acknowledge that future returns from those assets may be very different.
Government bonds are a case in point. Over the past 20 years, UK gilts have delivered an annual average return of 6.5 per cent. The reliability of this return explains why investors tend to be comfortable with a traditional 60:40 equity/bond split in their portfolios. But the assumption that sovereign bonds will continue to provide such returns looks unsafe. In the years since the financial crisis, we have heard a great deal about a "new normal" in interest rates: that they may be lower not just for longer, but for the foreseeable future too.
The implication of this new normal is that sovereign-bond returns will be significantly subdued. Current economic circumstances are very different to those of the decades leading up to the financial crisis. Today, the Bank of England’s interest rates are still close to zero, and the yield on the 10-year gilt is around 1 per cent. So expected returns of 1 to 2 per cent are more realistic than the 6 per cent plus to which investors have been accustomed. The logical conclusion is that a portfolio’s allocation to government bonds should be very low.
Meanwhile, after the bull market in equities since the financial crisis, stock-market valuations are looking stretched. While we see the corporate sector is in reasonable financial health and we are also reasonably optimistic on the prospects for corporate earnings, our return expectations for the next few years do not match the, in some cases double-digit, returns we have seen over the past few years.
In various regions around the world we are also seeing a “touch on the brakes” in terms of monetary policy. In some cases, such as the US, this is to get interest rates to a level that we might consider normal after the years of unconventional monetary policy after the financial crisis. In other regions, such as China, it is to rein in credit growth and to get growth rates to a more sustainable level.
All these factors suggest more modest returns from equity markets. But in addition, working-age populations are shrinking and their productivity is declining. A great demographic transition is underway, with ageing populations and falling fertility rates. This is already well established not only in the West, but in large parts of East Asia too. Both South Korea and Japan have lower birth rates than China, for example, despite the one-child policy that has only just been abandoned there.
The shift is a consequence of greater wealth, longer lives and cultural change. But it is resulting in an unprecedented situation in which working-age populations in the West and much of East Asia are shrinking, or soon will be. The net result will be much slower growth in the global economy – with obvious implications for equities.
That's not to say that there aren't still opportunities in equities: the European business cycle is showing some momentum at last, and emerging markets are still relatively cheap. But with bond returns likely to be severely constrained by the "new normal" in interest rates and equities held back by subdued global growth, some of the best opportunities in the years ahead are likely to be found in alternative assets.
So what are these alternatives? We think local-currency, emerging-market debt may offer returns comparable to those from developed-market sovereign debt in the past. Emerging-market governments have learnt from the past, and their economies are now more prudently run. Attractive returns are also likely from listed infrastructure investments in roads, hospitals and wind farms.
We also think that there are considerable attractions in private markets. Forward-looking investors are becoming increasingly open to these less liquid markets, given the higher returns on offer. The trade-off between illiquidity and long-term returns has growing appeal, especially as illiquid markets are inherently less volatile.
In the years ahead, equities and bonds will still be vital to many investors’ portfolios. But traditional 60:40 equity/bond allocations are unlikely to fare well. That model worked well when government bonds produced a 6 per cent return, but it won’t work when returns are just 1 per cent. Instead, combining equities with a diversified mix of higher-return alternative assets should offer investors better outcomes in the ‘new normal’ of low rates and slowing growth.
Craig Mackenzie is a senior investment strategist at Aberdeen Asset Management