James Pike considers the impact for charities of lower returns.
The last few years has witnessed an unprecedented monetary experiment being conducted by central banks which has led to interest rates all over the world falling to levels which were previously unheard of – no matter how many centuries one looks back. Accompanying programmes of quantitative easing (often referred to as printing money) have driven up the prices of government bonds and corporate bonds through direct buying by central banks. It has always been the case that an important determinant of future returns has been the starting valuation of the asset in question. Never has this been truer today: traditionally government bonds have been the anchor to which all asset prices are linked.
As a secondary effect, equity valuations have risen as investors take on more risk to compensate for the fact that yield is no longer achievable from the traditional safe havens in the form of cash and bonds. With asset class valuations looking expensive relative to history, this reduces the likelihood of outsized gains from current levels.
There are also structural pressures on the global economy that will likely result in lower levels of economic growth for the foreseeable future. Demographics within developed markets are almost certain to become a headwind to global growth, while productivity is at historically low levels, debt at historically high levels and a high degree of wealth inequality is leading to a rise in populism and protectionist (anti-globalisation) rhetoric.
It is important to consider whether the current low growth environment is likely to persist. Future returns over the next, say, ten years are likely to be lower than they have been over the last three or four decades. We believe that the outlook for financial markets in the mediumterm is weak and that historic returns are not a realistic or prudent place to start when considering future investment returns – in the medium term from today.
This does not mean that we will not have periods of high economic growth or strong markets, nor does it mean we will avoid recession or market weakness, but rather that the trend rate of growth for the global economy will likely be lower for longer. So what does this mean for your charity?
Option 1 – accept lower returns
Where a higher risk strategy will provide greater inflation protection; lower risk mandates will be more vulnerable to inflation risk, particularly in today’s environment.
A large proportion of charities stipulate an inflation-plus target for their investment managers. Over the longer term, these objectives should have been achieved. Given the headwinds of low interest rates and bond yields, charities should anticipate that the returns they have experienced over the past few years are unlikely to be achievable going forward. As asset values have risen, spending policies have increased and this may need to be adjusted to a more sustainable level. Those charities that have relied on these returns for income and distributions might need to consider their spending policy.
Option 2 – accept more risk
It is important to note that we expect returns over the coming years to be lower than in the past because the basic mathematics of ultra-low and negative bond yields mean that high returns are extremely difficult to achieve in what have historically been lower-risk assets such as bonds and cash. Therefore, charities may have to consider the underlying assets within their portfolio and their current asset allocation if they require a certain level of income or capital growth to fund a withdrawal/spending policy.
In order to achieve higher rates of return above inflation (also referred to as real returns) over the long term, investors should be expecting to accept a higher level of risk. This is usually measured using volatility – a measure of the variability of returns. For example, over the long term, global equities have produced volatility of around 16 per cent whereas developed market government bonds have been much less volatile at around 6 per cent.
We are well aware that charities are risk-averse with their investments. The Charity Commission’s guidance on investment matters (CC14) is clear on the point that charities can invest to produce the best financial return within a level of risk considered to be acceptable by the charity. So how do you measure an acceptable level of risk?
Generally speaking, higher risk mandates will provide greater inflation protection over time. However, it is important to understand that higher risk mandates come with more chance of drawdowns in the short term, albeit with the likelihood of larger gains in the long term. Therefore, the shorter your investment time horizon and the lower your capacity to cope with short term losses (perhaps because you have pressing cash requirements), the less you can afford to invest in a riskier strategy.
This is a backward-looking analysis and may not be repeated in the future, but it does support the generally accepted wisdom that higher returns do come with periods of negative performance.
Deciding on a suitable approach
In our meetings with various company management teams, we note that many are struggling to generate pricing power within their respective sectors and geographies, thus limiting their ability to grow revenues and, ultimately, earnings and dividends. This has resulted in a rationalisation of costs in order to maintain margin, as well as an increased issuance of debt or use of cash to refinance at a lower cost resorting to buying back shares, rather than investing for growth. Furthermore, companies have benefited from weak labour market conditions, enabling them to increase margins up until mid-2015. However, this multi-decade trend, largely fuelled by the globalisation of labour from previously closed economies, may be changing as we reach full employment and the populist policy of protectionism limits the available global labour arbitrage. An indicator that we have passed the inflection point is that German labour costs are allegedly lower now than those on the east coast of China.
Given such a weak global economic backdrop, we see little opportunity for companies to drive earnings per share (EPS) upwards (short of reducing the denominator in the EPS calculation by buying back further shares). Equity markets have been particularly strong of late and, in many regions, have been posting new highs. This would seem to suggest a great deal of confidence in the outlook for improving economic growth. However, there are very significant macro headwinds (debt, deflation, demographics to mention just three) as well as elevated geo-political risks. Given the likelihood of more subdued growth ahead, we think a muddlethrough scenario seems most likely and in this environment portfolios should be able to post reasonable yet unexciting returns, with periods of volatility.
When deciding on a suitable approach for your investments for the next few years, the most important type of risk to consider is the variability of returns and how this might impact on your charity’s spending.
James Pike is director, head of charities at Waverton
Civil Society Media wishes to thank Waverton for its support with this article