Future Fund lifts returns but inflation a major problem

The Future Fund warns that real investment returns are likely to remain below those of the past decade amid ‘persistent higher inflation’ and markets are underpricing ‘significant’ risk.

Australia’s Future Fund has warned that real investment returns are likely to remain below those of the past decade due to “persistent higher inflation” and that markets are underpricing “significant economic and geopolitical risk”.

The warning of lower inflation-adjusted returns and macroeconomic risks came as the sovereign wealth fund reported an improved annual return for the 2023 financial year after a “difficult” period in financial 2022.

For the year to 30 June, the Future Fund delivered a positive return of 6 per cent, compared to minus 3.7 per cent for the year to December 31, and a minus 1.2 per cent return in financial 2022.

Total funds under management rose to $206.14bn versus $196.12bn as at December 31.

The total funds invested by the board rose to a record $256bn.

Future Fund chair Peter Costello said the improved investment performance reflected the portfolio’s wider diversification across international markets and private assets.

“Over the past decade, the Future Fund has delivered an average annual return of 8.8 per cent per annum against a target of 6.9 per cent,” he said.

“Since 2006, with an initial contribution of $60.5bn, the Fund has earned more than $145bn and grown to its present $206.1bn at the end of June, without any further contributions.”

Mr Costello said the full impact of higher rates is yet to be seen, and recessions in developed economies remain a risk as central banks “remain vigilant in bringing inflation down.”

“Share markets were surprisingly strong through the second half of the financial year as they appeared to be pricing in a ‘Goldilocks’ scenario,” he added.

“Whilst this would be a welcome outcome, we see risks on the downside.”

He said it’s “far too early to say that interest rates in Australia have peaked.”

Defending the Fund’s annual return, he said was a “difficult year” as advanced economies experienced a spike in inflation, leading to higher interest rates which “produced a bit of weakness” in shares in the first half.

As investors began to think that central banks could produce a soft landing, he noted that inflation remains high and higher interest rates remain a risk.

“The data shows that particularly in relation to services, and to some degree wages, inflation pressures remain strong,” Mr Costello says.

“And so we would expect elevated interest rates to continue, and it’s far too early to say in Australia that interest rates have peaked.”

But while Mr Costello expects interest rates to “stay elevated”, he said the biggest concern is China.

“One of the things that is interesting us most and perhaps causing us most concern is China,” Mr Costello said. “There was a lot of positive sentiment about China when it emerged from its Covid lockdown, and that was priced into equity recovery to some degree.”

“But the housing market is under extreme stress, leverage is high, large companies are failing, such as Country Garden and Evergrande.”

He noted that China’s demographics are a “real problem” as its birth rate hits record lows.

“Most people are expecting some kind of government response to the situation,” Mr Costello said. “But if weakness emerges in China, that will have a big effect on Australia.”

In recent years, the growth of China has delivered Australia it’s greatest terms of trade since the gold rush, and weaker growth in China will have “quite a significant effect” on Australia.

“So looking forward, we see elevated interest rates, we see the possibility of our largest trading partner continuing in difficult circumstances – we think they are both risks to the investment climate – and we’re positioned quite conservatively going forward,” he added.

Mr Costello said the future fund’s board is focused on maintaining a portfolio that is resilient to a range of scenarios while delivering attractive risk-adjusted returns.

“With persistent higher inflation, we expect real returns to investors will remain below those of the past decade,” he said.

Echoing Mr Costello’s caution, Future Fund chief executive Raphael Arndt, said the favourable investment conditions that drove markets in recent decades have been undergoing profound changes.

“The Future Fund portfolio is positioned moderately below neutral risk settings at a time when the economic outlook and the direction of inflation and interest rates make investment returns less certain,” Mr Arndt said.

“We have made significant changes to the portfolio over the past two years, and this means that our holdings and returns will look increasingly different from those of other asset owners”.

“Although risk assets are underpricing some of the threats we see, higher interest rates are making it easier to generate meaningful returns from a diversified range of assets such as that owned by the Future Fund.”