By Mike Coop, chief investment officer of Morningstar Investment Management EMEA
It’s about that time when inboxes are full to the brim with predictions for the rest of the year. The fun part of investing is to think about the things that could happen.
But, of course, the future is inherently uncertain. We only have to look to the more recent past to recognise that few could have prophesied the worldwide events witnessed since early 2020.
Predictions are biased heavily by what has just happened and people tend to put too much emphasis on the situation in question.
Some big shocks have altered the outlook dramatically. Yet returns tend to become more predictable over longer-term horizons, due to mean reversion in fundamentals and investor expectations about the future.
I’ll share what we have found at Morningstar Wealth to be the best guide to market returns and how to build investment portfolios to meet investment goals.
Let’s start with equities: the key asset for building wealth and growing income. Current prices imply average returns of circa 4% p.a. above the rate of inflation for world equities, based on expected income from dividends and share buybacks, growth in corporate earnings and shifts in valuation.
Our forecast returns are somewhat lower for US equities, reflecting higher than usual share prices for dominant US companies and an expected pull back from peak levels of profitability. The UK and emerging markets are poised to generate higher returns, based on more modest expectations baked into today’s share prices.
Around this average we expect equity returns to vary considerably, in line with longer-term levels of volatility. Over the past 10 years US annual returns varied from +31% in 2013 to -18% in 2022 (Morningstar), a variation of up to 50%.
Typically swings in investor expectations between optimism and pessimism cause share prices to move by much more than can be explained by just changes in dividends, share buybacks and growth in corporate profits. It’s this sentiment element that is the least predictable of the three return drivers in the short term.
For bonds, returns are more predictable than equities because of the fixed nature of the payments investors receive, but prices do still fluctuate based on changes in actual and expected interest rates, which in turn, key off actual and expected inflation. These shifts in inflation and hence interest rates have been especially large in recent years, explaining why US bond annual returns have ranged from -18% to +11% (Morningstar) over the past decade.
With inflationary pressures easing and interest rates have risen a lot over a short period, we see current bond yields as a good predictor of average annual returns. You can get 4.5-5.0% pa from UK government bonds and 6.0-6.5% pa from UK investment grade corporate bonds, broadly similar returns from comparable international bond markets on a currency hedged basis and higher returns from emerging market government bonds and high yield corporate bonds. After their sell off, UK inflation linked bonds offer positive returns after inflation for the first time in many years. So, bonds are priced to generate higher returns than inflation.
From a currency perspective, the strong signal from our research is that the US dollar is trading at high levels versus the pound, and the Japanese yen is trading at very low levels. This is based on the outlook for inflation, interest rates and the fundamentals impacting trade and capital flows.
Bringing this all together, multi-asset investors can look forward to higher real returns because the rise in interest rates have lifted returns from bonds and cash while bringing down inflationary pressures.
Portfolios always need to be able to handle a variety of scenarios beyond what seems most likely to occur today.
So, what is 2024 likely to have in store? Well in the coming weeks, I’m sure we’ll see even more emails predicting what’s coming down the line. But more importantly plenty of advisers helping clients reach their financial goals throughout the whole year.
