Investors are looking at “well below normal” returns from developed market equities and bonds over the next five years, according to Luca Paolini, chief strategist at Pictet Asset Management, who says anyone looking for better returns needs to radically rethink their risk tolerance.
Leveraging risk is the primary driver of investment in securities and therefore any potential appreciation in value has to come with a degree of possibility that investors could lose some or all of their original stake.
The past five years or so have been a period where most bonds and equities in regular markets have moved upward, buoyed by easy monetary policy and a gradual recovery in the world economy and mainstream asset markets following the dark days of the financial crisis.
Performance of indices over 5yrs
Source: FE Analytics
However, this movement upwards has caused the next five years to offer scant opportunities in conventional assets and has prompted anyone hoping for something better than ‘meagre’ returns to buy into 'riskier' places such as emerging markets equities and debt as well as currency and technology stocks, according to Paolini.
“I'm afraid I cannot see any safe havens. If you want returns and yield you are going to have to take risks. Investors have been going into the equity space and looking for the dividends that are very solid such as in the consumer sector but I am not convinced this is really safe,” he said.
“There is no relatively risk free, non-cyclical asset classes that is actually cheap. You can find this in emerging markets, but there is a [greater] risk, or in currencies. For example, you can find in the Norwegian kronar - you can say Norway is the safest place on earth, in theory and also the cheapest currency but if you look at the correlation with oil it is 90 per cent. So in theory it is very safe but actually it is not – it is very cyclical.”
FE Trustnet news editor Gary Jackson is one such investor viewing the investment landscape and finding little to excite to him in conventional spaces, as well as fearing a six-year bull market makes for increasing risk for a period of downside.
Paolini says we are in a “high risk, low return” environment for the next five years although he thinks there is still some opportunity for investors willing to take on more risk.
“You have to take more risks to achieve the same return or you have to be better. You have to time the market in a better way and be more tactical. In the last five years buying a passive 50/50 [bonds and equities] portfolio as a good idea. Now it is not going to work. You are not going to be happy with your returns over five years.”
However, secular opportunities still abound in markets and Paolini is overweight Europe and Japan stocks, which he believes stand to benefit from ongoing central bank support.
“In our sector allocation, we keep our preference for attractively-valued sectors most likely to benefit from strengthening global economic growth. The technology sector’s prospects look particularly good and we upgrade it to a full overweight,” he said.
“The tech sector now trades at a discount to the global equity market based on prospective earnings. To us, this valuation gap is unwarranted as tech stocks are expected to deliver 30 per cent more earnings growth than other sectors over the next five years. Companies operating in the sector are also better equipped to hold up in a rising rate environment because they are cash rich.”
The strategist says emerging market equities will offer the best average annual returns over the next five years but that investors should hold on and buy a likely correction later this year prompted by fear of rising interest rates in the US.
“In the short-term emerging markets are most at risk. If the Federal Reserve moves aggressively to raise rates, I can tell you that you don't want to be there – in the short term. But talking about five years you are going to great opportunities, particularly if you wait until after a significant period of downside.”
About a third of Paolini’s forecasted 15.5 per cent annualised returns from emerging market equites is predicating on the US dollar losing value from its current strength over the next five years.
Over the past year the pound and the euro have taken a huge hit relative to the dollar with the pound down 7.94 per cent and the euro down 17.18 per cent.
Performance of indices over 5yrs
Source: FE Analytics
Angus Campbell, senior analyst at currency broker FXPro, says “unquestionably” last month’s non-farm payroll data from the US was robust enough to imply a blatant shift in expectations of a hike slightly earlier than September, raising the potential for the dollar to bounce to very soon.
“A great deal of attention has been placed on when the tightening cycle will start and it wasn’t too long ago that many were expecting tonight to mark the first rate hike, however the Fed is trying to shift the market’s focus onto the tightening cycle as a whole, which means not just when it will start, but when and where it will peak,” he said.