For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
We wrote recently addressing the question, coming from many advisers, about mortgage rates and fixed rate investment products. Many end clients are wanting to switch into the more certain return offers of fixed rates or even use their investment portfolios to pay down mortgages.
In the earlier note, we addressed this from the point of view of history and inflation. This article addresses from the opposite angle, what are the potential investment returns on a mixed asset from here. Or simply put, how bad does it have to get for our portfolios not to beat cash or fixed rate products over the next few years?
Clearly, we are loath to make forecasts of future returns, this is always a mistake as the future is unknowable. It is, however, possible to put reasonable assumptions down and then challenge those to consider what circumstances would need to arise for these assumptions to be wrong.
When we look at our portfolios today, we see some of the most attractive metrics that we have seen in a long time. Starting with the bond portfolios these have yield to maturity of between 6% and 8% (as at 22.08.23) depending on the risk profile of the fund. For comparison the 5 year corporate bond index yields 6.3% (as at 22.08.23). They also have durations around 3 years, and hence, pretty low interest rate sensitivity. In simple terms over 3 years this part of the portfolio is highly likely to earn the yield.
When considering the equity portion of portfolios naturally things are more uncertain. Starting with some valuation metrics, dividend yields on our equity portfolios are between 3.3% and 4.7% (as at 22.08.23), again depending on the risk profile of the portfolios. Price to earnings ratios are between 11 times and 12.5 times. Naturally, these valuations could potentially fall further, particularly in a recessionary environment but over the longer term these seem very attractive levels. If, as we do, you think the greater likelihood is that inflation continues to be higher for longer, then it is reasonable to expect equity dividend growth to be higher than in the past. This is likely to be particularly the case for the companies that we emphasise, with strong asset bases and inflation resilient businesses.
Just taking the income level on the funds, ignoring any possibility of equity price rises or any return from the other assets in the portfolios, you get to a mid-single digit return. A return less than the income means negative capital returns. This would require equity prices to fall further and very significant further rises in bond yields.
Global equity markets peaked in May 2021, for them to fall further in absolute or real terms would imply we are in one of the most extended bear market phases of recent history. Obviously not impossible, but something of an extreme scenario. In historical terms, it is very rare to not have made a new high within 5 years of a previous high. Even from the tech bubble highs in 2000 the world index was making new highs by 2006.
In our view, clients are wanting to de-risk portfolios at exactly the worst time, bonds have recently experienced some of the worst returns for many years and yields are now much more attractive. Our very short maturity portfolios will mature, earning the yields to maturity we currently see. If we are correct, we should be able to reinvest these proceeds at even higher yields going forward. We base this on the assumption that inflation is persisting into the medium term.
While world equity indices may have peaked in 2021, this masks the fact that equity indices, outside the US, have been broadly flat since before the GFC. We think it pretty implausible that over the medium term equity valuations fall materially from here and in an environment of continued inflation, earnings growth is likely to be higher, particularly for the inflation beneficiaries we own.
Hence, overall, we think it very unlikely that our portfolios don’t earn returns significantly above those on offer from fixed rate life bonds or annuities. At the end of the day, life companies own the same assets as we do, can do the same maths as us and expect to earn much higher fees than we charge, in exchange for the certainty of the fixed returns on offer. We believe now is not the time to sell unless you think we are in the early stages of one of the longest bear markets in history.
