By Pictet Asset Management chief strategist Luca Paolini
Investors looking to replicate the returns of the last five years in the next five should embrace the mantra ‘adapt to thrive’. This is because a considerable amount of disruption looms with slower growth, more volatile markets, less business-friendly governments and a squeeze on corporate profits.
But investors who know where to look can still navigate the pitfalls by seeking exposure to select pockets of growth with emerging market stocks, particularly in Asia, poised to deliver double-digit returns annual returns to the end of the decade. Pictet Asset Management’s Secular Outlook for the coming five years identifies the key trends and how to harness the best opportunities.
“The next five to 10 years are going to be a very difficult time for investors but we still believe there are some very interesting opportunities,” said Pictet Asset Management chief strategist Luca Paolini.
Key trends and opportunities for the next five years include:
- Developed equities have further to run but at a slower pace than we saw in recent years. We expect a mid-single digit annualised percentage return in dollar terms to 2020.
Working against developed market stocks are their high valuations in the wake of a multi-year bull market. Political risk also plays a part. In the face of rising income inequality, governments are under pressure to shift the tax burden away from individuals onto companies, raise minimum wage levels and tighten regulation, all of which eats into profit margins.
That said, we could see positive surprises with growth exceeds expectations. Companies are investing heavily in research and innovation that should deliver operational improvements. With research and development as a percentage of GDP in the US at an all-time high, there is scope for a significant boost to returns if this translates into higher productivity growth.
- Economic growth in the developing world will slow but low initial stock valuations bode well for emerging market equities which we expect to deliver 12-15 per cent annualised returns in dollar terms.
China is not expected to deliver the rapid growth rates of recent years which is not helpful for other emerging markets as it accounted for about half the developing world’s growth over the past five years. On the other hand, economies with reform-minded governments and favourable demographics, particularly India, look well placed. Against this mixed picture for economic growth, emerging market equities have reached extremely attractive levels and are around 25% cheaper than developed market counterparts on a price-earnings basis. This gap should narrow as emerging market corporates become more competitive thanks to cheaper EM currencies and improvements in productivity stemming from economic reforms.
- Interest rates will stay low as deleveraging continues and economic recovery remains too slow to justify an aggressive tightening.
A structural trend for persistently low interest rates is likely to fuel expansion in consumer demand for credit presenting investors with niche opportunities in areas like auto finance which can be harnessed by increasing exposure to banks and other more specialist lenders. Low interest rates also make commercial property an interesting opportunity, offering more attractive yields and growth prospects than residential real estate which is likely to be held back by macro-prudential regulation of mortgage markets.
- The end of the 30-year bull market in developed market government and investment grade bonds – High valuations and the prospect of a gradual rise in US interest rates are our main concern. While sovereign debt will remain the asset class of choice for the developed world’s ageing investors and highly regulated financial institutions, it is clear that technical developments are more favourable for stocks than bonds. This is borne out by investment flows. Relative to equities, flows into development market government bonds have reached their highest ever levels, Once economic conditions improve, it is reasonable to expect this trend to reverse, favouring stocks at the expense of government debt and investment grade credit.
- Higher-yielding fixed income such as emerging market sovereign and corporate debt and non-investment grade bondshould fare better than their developed or higher-grade counterparts.
USD-denominated emerging market government and corporate debt are trading at levels below their fair value. True, Venezuela and Ukraine may have tarnished the image of EM debt, but they are not representative of the asset class as a whole. EM local currency sovereign bonds should also perform better than their developed market counterparts. The potential for yields to rise remains limited as we expect a number of central banks to loosen monetary policy over the next five years as inflation eases.