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Equities are the top picks for the next five years

Equities are the top picks for the next five years

03-10-2014 | 5-Year outlook

Equities will deliver the best returns over the next five years, with emerging market stocks at the top of the tree, says Robeco’s CIO of Investment Solutions.

Speed read

  • Stocks expected to return 5.5% a year
  • Emerging market equities are top picks
  • AAA-bond returns seen as low as 0.25%
  • Three scenarios adopted for next 5 years

Lukas Daalder predicts that developed market stocks will return 5.5% a year from 2015-19 while emerging market equities are set to deliver 6.75%. This is considerably above the expected returns from bonds, where a gradual normalization of economic growth means interest rates will eventually rise from their historic lows, raising bond yields but lowering their prices.

AAA-rated government bonds are seen returning as little as 0.25% a year, below the rate of inflation in most countries, though high yield bonds and emerging market debt should offer more at 2.0%. Of the other major asset classes, indirect investment in real estate (through financial investments rather than physical property) is seen as returning 4.0% a year from 2015-19, while commodity market returns are seen dropping substantially.

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Economic growth favors stocks

“Strengthening economic growth and low inflation create a more favorable environment for stocks compared to bonds,” says Daalder, Chief Investment Officer for Robeco Investment Solutions.

“On an absolute basis, the returns for developed market stocks are forecasted to be lower than during the prior five-year period at 5.5% a year. But in relative terms, as an excess return over government bonds, stocks are still expected to yield above-average returns.”

However, while equities are the clear favorite, Daalder cautions that stock market returns are seen being lower than those forecast in the previous edition of Expected Returns covering the 2014-18 period. He argues that the long bull run for equities since the market bottomed out in 2009 has made some valuations inflated, and that stock prices will fall more into line with the actual earnings growth of companies.

‘Stocks are expected to yield above-average returns’

“The continued strong rally in equities recent years has not been matched with earnings growth, leading to stretched valuations (overvaluation) for the asset class as a whole,” he says.

“But following a year of underperformance, emerging market stocks look to be the most interesting option, as their valuation versus developed markets is now low. Investors should be mindful of course that volatility for this asset class is traditionally higher, though it has declined in recent years.” The table below shows the volatilities that can be expected from each asset class, with emerging markets clearly showing the highest levels for stocks over bonds.

Equities rule: our predictions for the major asset classes for the next five years

Source: Robeco

Three scenarios for recovery

Daalder and his team use three scenarios for predicting returns. The preferred one is a ‘gradual normalization’, which he and his team believe has a 60% probability of occuring. There is a more pessimistic one of ‘secular stagnation’, which is given a 30% chance of happening; and a more optimistic one of ‘strong recovery’, which has a 10% likelihood of coming to pass. Daalder sees the US economy, which has been going from strength to strength, taking the global lead.

“The central idea with a gradual normalization scenario is that all hangovers eventually lift, even those from a financial crisis,” he says. “Given the fact that the subprime mortgage crisis in the US (2007-2009) erupted earlier than the Eurozone crisis (2010-2012), it is not surprising that the US will take the lead in this process.”

“Interest rates will be raised, although policymakers are expected to choose a gradual approach, rather than being too aggressive. Growth will be supported by a recovery in labor markets and investments, but at the same time will be held back by demographics and (especially for Europe) the slow healing process of the recovery of the banking sector. Inflation in this scenario will pick up, but is not likely to pose a threat for financial markets.”

In the ‘secular stagnation’ scenario, the world continues on the path which we have seen over the past five years, with modest growth for the world economy as a whole, and no growth or mild deflation in the Eurozone.

‘Policymakers will choose a gradual approach and won’t be aggressive’

“In this scenario the weight of an ageing population and the lack of meaningful technological change that helps the whole of the economy (rather than the lucky few) prevents growth from moving into a higher gear,” says Daalder. “It would mean that ‘Abenomics’ fails in Japan and China weakens. Bonds and real estate would be the relative winners in this scenario, as monetary authorities will continue to push yields lower in hope of reviving the ailing economies.”

He says a far happier outcome for the world economy as a whole would be the ‘strong recovery’ scenario, where investments are thriving, productivity gains translate into higher earnings, and economic growth is gathering strength globally.

But don’t hold your breath – the chance of this happening is put at no higher than one in 10. “And this scenario is not without its own drawbacks,” says Daalder. “Inflation would at long last return to haunt central banks and investors alike. As such, with the exception of cash, most asset classes would end up with a lower return compared to our central scenario. Higher refinancing rates and higher wages would pressure earnings margins, while bonds would suffer from an across-the-board sell-off.”

Alternative scenarios, where arrows show differences versus the central scenario

Source: Robeco

The past predicting the future

Daalder says one of the reasons why the next five years are not expected to be as lucrative as the past five is because abnormally low interest rates since the financial crisis have artificially distorted returns since 2009.

“Five years out, returns have to be seen within the context of the current state of the world economy, and the developments we have seen over the past five years or so,” he says.

“From an investor perspective, the past five years have been pretty impressive – all of the major asset categories have yielded returns well in excess of their longer-term average, with listed real estate leading the pack, boasting a 16% annualized return,” he says (see chart below).

Annualized returns from September 2009 – September 2014

Source: Robeco

From an economic perspective however, the developments have been a lot less impressive. “The world economy as a whole managed to keep up its average growth rate, but this was mainly thanks to the very strong growth performance of the developing countries: growth in the advanced economies has been lagging,” he says.

“There has been no strong rebound from the major blow that was dealt during the 2008-2009 recession, with especially Europe only showing lackluster growth. Recoveries following a financial crisis are usually weak and the current one is no exception. It has pushed central banks around the world to keep interest rates close to zero, while trying to revive their economies by embarking on various unconventional monetary measures, all aimed at flooding the system with ample liquidity.”

“This has been the driving force for the returns we have seen in the various asset classes. Liquidity has pushed interest rates and bond yields to unprecedented lows, forcing investors to look for returns elsewhere. Valuations in various asset categories have been pushed to stretched levels, which have a clear impact on the expected returns for the years to come.”

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