Why Australian shares will beat Wall Street
Over the next decade, based on our empirically informed understanding of capital markets, we expect both Australian and emerging market equities to outperform the remaining developed market equities, the US market in particular. Our forecast is that emerging markets will significantly better inflation at a 5.2 per cent annualised real return. Australia is set to deliver 4.5 per cent.
Our models tell us developed equities are expected to tread water, delivering 0.8 per cent a year in real terms, underpinned by the expectation that US equities will lose 1.3 per cent per year in real terms for the next decade.
Some investors may be disappointed with these capital market expectations, especially given the global equity returns of the last decade, but these forecasts capture the forward-looking reality of capital markets, given current conditions. We encourage investors to have realistic expectations. Realistic, to be clear, does not mean conservative for the sake of creating a buffer against disappointment, but rather an unbiased view of the future — as likely to surprise to the downside as to the upside — so that they can invest and plan accordingly.
The Research Affiliates AAI forecasts, based on an empirically driven quantitative model, do not highlight any asset class with a current annualised real expected return in excess of 10 per cent over the coming decade. Emerging market equities are at the high end of expectations, sporting an annualised 5.2 per cent real return throughout the 2020s. The diversifiers in any portfolio, bonds, government and corporate, as well as commodities, look particularly disappointing.
The current yield on Australian government bonds is within a rounding error of the expected rate of inflation. Global markets offer us a similar situation. We wish we could be more exuberant, but that would be a disservice to all if we ignored the facts.
As we look back, the most recent decade has had an extraordinary place in modern history. Since the end of World War II, and zeroing in on the US for this application, the 2010s recorded the lowest inflation, the lowest average yield on 10-year US Treasuries and a dramatic reduction in civilian unemployment.
The global equity market returned nearly 10 per cent a year real (that is, net of inflation) for an Australian investor while global bond returns came in at 2.9 per cent after inflation, wrapping up a three-decade decline in bond yields since the high inflation of the pre-Volker era.
One asset class is worth highlighting in the 2010s: high-yield bonds. At the centre of the 2007–2009 global meltdown, high yield has witnessed a very strong recovery over the last decade. US high-yield bonds (hedged into Australian dollars) out-performed the US equity market with real returns of 7.5 per cent per year.
However, past is not prologue. Past returns are poor — even perverse — predictors of future returns. Investors should not expect a repeat of this post-GFC performance in high-yield bonds. The current yield on these lower credit rating bonds is barely above the expected losses from the companies that back them. If high-yield bonds have been a success story since the GFC, we should not expect more of the same as we step into the 2020s.
Said another way, the price of an asset matters: richly priced assets tend to deliver underwhelming returns, while relatively inexpensive assets are better positioned to deliver healthy returns over the medium to long term. As prices rise, delivering high historical returns, yields fall, requiring us to revise down, not up, future returns.
Rob Arnott is the founder and chairman of the board at California-based Research Affiliates and Mike Aked is director of research for Australia.
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