The signal from our long term expected real returns has provided us outsized alpha in the last two years as the Covid induced markets’ crash in 2020 gave a unique opportunity to buy cheap equities. However, as these higher returns have come through, they have reduced future returns. We also have a big new theme, liquidity reduction, which will dominate markets for the next couple of years. Our philosophy of theme and price looks at both the valuation and the environment. Central bank tightening, led by the Federal Reserve, will create a headwind for asset prices as the real cost of capital edges higher.
Much of this liquidity tightening is a simple reversal of extreme policy BUT it is also in response to growing inflationary pressure. One of the key changes we have made in our long-term assumptions is that we have hiked developed world inflation to 2% over the next five years. This is 0.5% higher than our previous assumption of 1.5%. We are clear that cyclical inflation pressures will abate, and inflation will fall from its record high levels in the next year. We also think the fear of 1970’s type inflation is a “straw man” and don’t expect run-away inflation. Rather we are highlighting an uptrend in secular inflation driven by more fragmented global supply chains, the cost of the green energy transition and a growing share of GDP moving to government and labour. This change in forecast cuts our expected real returns for offshore bonds and cash by 0.5% to -1.5% and -2.0% respectively.
Global equity stands out on a relative basis, but the expected return of 4% is well below long-term real returns of roughly 6% per annum. This reflects the high valuation on US shares, which dominate global markets accounting for c.60% of the MSCI All Country World Index (ACWI). The rest of the world is much cheaper and should deliver higher real returns. The message from our global return expectations is clear: we are in a lower return world, the old 60:40 construct is dead, and we can expect more volatile returns. Even though global cash gives the worst real return, we think it will have valuable periods of protecting portfolios.
South African assets still offer excellent real returns, which are superior to what we can achieve offshore. The fundamental driver of this is cheaper valuations, driven by our higher cost of capital. In fact, South African nominal bonds are offering a 5% real return. We have cut the expected return on domestic property to 6.5%. This follows a sharp re-rating from ridiculously cheap levels but has not been backed by an improvement in pricing power. Despite SA property and SA equity having the same return expectations, we prefer SA equity as it has better growth potential. Interest rates in South Africa have troughed and will rise in line with the global trend . However, this will not be enough to deliver a decent real return and we prefer other South African assets. We have not made any assumptions about real currency movements but following the appreciation since Covid, the rand is no longer an obvious overweight. As such we recommend diversification within a savings strategy. The challenge is that this diversification will lower total returns.