There is no doubt that periods since around 1980 have seen a narrowing in the gap (or the risk premium) between share returns and bond and cash returns However, it would be dangerous to conclude that this is a guide to the future.
Returns from cash were pushed up in the 1970s when cash rates and other short term interest rates rose on the back of high inflation. Through the 1980s, short-term interest rates averaged 14.5% and term deposit rates averaged around 12.5% in Australia. In the early 1980s bond yields reached double digit levels, in fact reaching a record 16.4% in 1982. This led to very high returns from both asset classes over periods encompassing such high yields.
The decline in bond yields from the early 1980s was driven by the adjustment from high inflation to low inflation and more recently by worries about global deflation. It has generated huge capital growth and hence returns for bond investors.
However, the days of high returns from cash and government bonds are fading. If you buy an Australian 10-year bond today and hold it to maturity you will get 2.9% per annum. The official cash rate is just 3.5% and bank term deposit rates are averaging below 5%.
It is always possible that we have entered a “new era” of permanently poor returns form shares. But history cautions against such thinking. As the investor Sir John Templeton once observed, “the four most dangerous words in investing are: this time it’s different”. Claims of new eras of permanently higher returns from shares were seen at the end of long-term bull markets in the late 1920s, late 1960s and late 1990s – only to look nonsensical a few years later.
Similarly, after a decade of poor returns, Business Week magazine concluded in 1979 that we have seen “The Death of Equities”, with the argument that after a decade of poor returns investors had abandoned shares for good. Through the 1980s and 1990s shares then had a strong bull market.
While the current poor patch for shares may seem unusual, in a historical context it is not. In many ways it resembles the 1970s. Both periods suffered from the excesses of a long period of high returns and dysfunctional economic policies.
While cycles vary, investor thinking is very much following the rollercoaster of investor emotion devised by Russell Investments many years ago to show how investor psychology evolves through investment cycles. During a bull market ‘optimism’ eventually gives way to ‘euphoria’. When a bear market begins, investors initially see it as a short-term setback and remind themselves that they are long-term investors. But as ‘anxiety’ gives way to ‘fear’ investors eventually become ‘despondent’ and ‘capitulate’ by selling their investments thinking that maybe shares aren’t for them.
The longer the down cycle, the greater the capitulation and despondency, and this is arguably what we are seeing now: Much as we saw through the 1970s bear market in shares when it eventually led to calls of the “death of equities”.
But as long as the capitalist system continues and economies eventually recover, then history tells us that shares will eventually bounce back and that there is no reason to doubt that over long periods they will provide higher returns than cash and bonds. With grossed up dividend yields on Australian shares above 6% at a time when cash and term deposit rates in Australia have fallen well below 5% and bond yields have fallen to record lows, shares only need modest capital growth to easily outperform.
The key points are that the current period of poor returns for shares is not particularly unusual, investor sentiment (and cashflows) is doing what it normally does after an extended bear market in shares and it is dangerous to conclude that shares will no longer provide a higher long-term return than cash and bonds. So, putting aside the case for asset allocation in a more volatile world, for those who can take a long-term investment horizon it still makes sense to stick to agreed strategies involving a bias to shares even though they have failed to deliver over the last few years.
Dr Shane Oliver is the Head of Investment Strategy and Chief Economist at AMP Capital Investors. This article should not be seen as investment advice and has been written for general information purposes only.
