With markets sitting at very low long term interest rates, investors are in for a period of low long term returns, potentially as low as mid to low single-digit returns, in the traditional investment classes of equities, fixed interest, and real estate.
So what does that mean for Risk-Adjusted Returns? Does a lower return outlook mean that we are receiving these returns for a lower-level risk (along the lines of lower returns go with lower risk and vice versa), or will the risk level stay the same?
Looking at the past 40 years we have seen the Australian 10-year bond rate fall from over 15% pa to around 1% pa today. During this period where long term rates fell, investors got a "free kick" in terms of their returns, as
- their equities increased in values as shown through higher PE ratios,
- bonds naturally increase in value with lower interest rates, and
- real estate values increase with falling discount rates and cap rates.
An interesting observation is if you apply PE Ratio logic to 10-year bonds, we have gone from a PE of 6.67x, to 100x. Clearly, the cost of buying future income is getting very expensive!
Today, this "free kick" is nearly all but gone, so the future will have some payback. Whilst we don't know if rates will start rising next year or in 20 years' time, one can be confident that at some point they will go up.
This risk is a "different risk" to what we have been used to in recent times and will increase the risk of all asset classes, both in terms of variability of return, risk of loss in income and/or capital risk. This risk will be unrewarded in the traditional sense, so it is likely that we will be seeing lower returns in the future, for similar (or arguably greater) levels of risk.
Investment strategies will need to re-think their asset-liability matching strategies going forward, and it is likely that new investment approaches will need to be followed to ensure that acceptable outcomes are delivered to investors.
Leo Economides
