Investment returns from the major UK asset markets have been modest so far in 2004. Compared to the recovery of 2003 the stock market has been dull. Gilt returns are unlikely to be higher than the 4.8% yield on the 10-year at the beginning of the year. Overseas equity returns have been mixed, with returns from the US and Europe undermined by sterling strength.
This is a far cry from much of the 1980s and 1990s when declining inflation and interest rates boosted real returns from both equities and bonds. A balanced portfolio of half UK equities and half UK government bonds, passively invested and re-balanced annually, would have delivered an average of 10% annually in the period of 1980-1999. A random tactical asset allocation switching between equities and bonds at the end of each year would have produced 8.7% annually, while a 100% equity exposure would have delivered a whopping 13% annually in total real return.
We have relatively cautious expectations on the medium-term outlook for equity and bond returns, and judge markets currently to be close to fair value. Our asset allocation process is based on a simple framework in which we judge current implied market returns against long-term expectations. When there is a valuation anomaly we will take a tactical asset allocation position, providing it is consistent with our view on the business cycle.
For bonds, returns over the long-term are expected to be close to nominal GDP growth with a risk premium reflecting the uncertainty over future inflation. In the case of the UK, that breaks down to a 2.5% real growth rate plus inflation (represented by our view on the RPIX) of 2.5%. Total returns are thus expected to be slightly above 5.0% annually on average, depending on the risk premium.
The premium for holding riskier equities over bonds has averaged 3% in the UK since the early 1960s. Add this to expected bond returns and our medium-term expectations of returns from the UK market is around 8%. In real terms, returns from bonds and equities are both expected to be well below those achieved in the 1980s and 1990s.
Currently, 10-year gilt yields are 4.9%. That makes them slightly expensive. We currently hold an underweight position in all fixed income and prefer index-linked bonds to conventional gilts. Our view on the business cycle also suggests a cautious view on bonds. The BoE has been raising interest rates for close to a year now and, although base rates are probably close to a peak, it remains too early to call an end to monetary tightening.
The Federal Reserve is still at the beginning of the process of tightening US monetary policy. We see the potential for US interest rates to increase by around another 3-4% over the next couple of years, which may push US Treasury bond yields up from their current low level of 4.2%. Given the high level of correlation between major government bond markets, there is a threat to UK gilts from a more general global bond market sell off.
The dividend yield on the UK equity market is currently around 3.6%. We expect dividends to grow in line with GDP at around 2.5% annually, on average. That suggests a total return from UK equities of around 6% real and 8.5% nominal. Again, this is close to long-term expectations but it does suggest a current equity risk premium of around 3.6%.
This is not enough in our view to warrant an aggressive position in equities. The potential for global inflation to move higher suggests that eventually higher yields will be needed on both equities and bonds and that will limit real returns. Furthermore, recent economic data suggests that the pace of global economic growth is slowing. We do not see the risk of recession being very high, given that that there has not been a significant increase in inventories or employment. However, high oil prices and rising interest rates do point to a slowing of global growth in 2005.
A relatively stable business cycle, a low return environment and markets close to fair value suggests limited tactical asset allocation activity. Some may be tempted to try and ‘trade the range’ in equities and bonds, but market timing can just as easily turn out to be ‘market mistiming’.
Instead, we prefer a diversified approach, spreading risk between traditional bonds and equities, and alternative assets such as hedge funds, private equity, property and even commodities. Returns from any of these may not be significantly higher than from bonds or equities but they provide a diversification of risk that is important in a low return environment.
Such an approach should be judged against cash as the performance benchmark.
Chris Iggo is head of strategy at Cazenove Asset Management in London