Secrets of Success: Low inflation: how it's going to cost you

It is evident that most forecasts about the financial markets you will find in the media and on screens in the City are short-term in nature, and, as a result, of little practical value.

It is evident that most forecasts about the financial markets you will find in the media and on screens in the City are short-term in nature, and, as a result, of little practical value. The world is an exciting place, and it is the job of markets to reflect both the changing nature of events and investors' perceptions of them.

In the short-term these are bound to produce volatile patterns in prices, as participants act on their changing perceptions and those whose job is to keep the markets liquid and ticking try to earn a living. How volatile a particular market is depends on the nature of the asset concerned. Equities are traditionally more volatile than corporate bonds, which in turn are more volatile than gilts and commercial property.

As information about prices is available 24 hours a day, the challenge for investors is to distinguish the chatter of daily trading activity from the more important tectonic shifts in asset class performance that occur over many years. There is, unfortunately, little evidence that attempts to forecast or model these long-term patterns are always of much greater value than the short-term finger in the air efforts that are so popular around this time of year.

But the exercise has to be done and the mere act of doing it can produce useful insights. One institution that has returned to this theme is Standard Life, the mutual life company which, after years of banging the drum for mutuality, is proposing to demutualise.

As a result it has had to revamp its investment strategy, cutting back on its traditional high exposure to equities in favour of a more cautious, market-sensitive approach. Like many corporate pension funds, as a provider of long-term savings products Standard Life has been caught between the twin pincers of falling market returns and rising bond yields. This combination has simultaneously increased the present value of its liabilities and reduced the value of its assets.

The annual analysis of the investment outlook from the company's strategy team is always a thought-provoking production. Its central case this year is that equities will again provide the highest returns of all asset classes over the next 20 years, but that the proportion of equities which should be held in an optimally-weighted portfolio should be reduced and balanced by higher holdings of other asset classes, principally property and corporate bonds.

At the same time it suggests that the real return on corporate bonds and property will be lower than their historical average, while the return on gilts and cash will be higher than average. The return from equities could be higher than the long run real return of 6.5 per cent, though the odds are that it will come in lower than that.

In round numbers the forecast is for the real return on equities over 20 years to fall within a range of 1.0 per cent to 7.5 per cent, against a historic figure of 5.3 per cent per annum. For government bonds, the equivalent figures are 1.5 per cent to 3.0 per cent (against a historic figure of 1.3 per cent): for corporate bonds 1.5 per cent to 3.0 per cent (against a recent average of 6.3 per cent); and for commercial property 2.0 per cent to 8.0 per cent (against 6.5 per cent since 1987).

These numbers underline what has become the central orthodoxy of the current period, namely that investment returns are likely to be much lower in general over the next 20 years than they have been in the last 20 years. This is indeed likely to be the case as long as inflation remains at around its current level, namely 2 per cent or so. Low single figure real returns are almost certainly the best result that can be achieved if at a global level the control of inflation continues.

This has an interesting implication for portfolio composition. Whereas a high equity content has often been favoured by long-term investment institutions, on the grounds that equities return the best returns over time, even after allowing for their added riskiness, this case becomes weaker when the differential between the returns from the various asset classes narrows. While equities are still projected to provide the highest returns, the possible margin of outperformance allowing for risk is not so great any more as to justify such a big weighting.

In an unconstrained port-folio, Standard Life's analysis suggests, the optimal proportions to secure the best risk-reward combination are likely to come from having around a third in corporate bonds, a fifth in equities, a quarter in property and a fifth in gilts. That is a very different looking portfolio than the traditional pension fund portfolio. In practice many portfolios are measured against a standardised benchmark of perhaps 40 per cent in equities and gilts, and 10 per cent in property and corporate bonds.

What this underlines is the fact that the current investment climate demands a different approach to asset allocation than everyone had got used to in the easy bull market years of the 1980s and 1990s. The biggest problem with the whole approach however, as Standard Life concedes, is that any such exercises are only as good as their assumptions.

In particular, the whole exercise could be thrown out of kilter if the central assumption - that central bankers and governments can continue to keep inflation controlled without either the risk of deflation on the one hand or renewed inflation on the other - turns out to be wrong. This is a live issue at the moment, indeed arguably the most important facing investors. Different outcomes will require very different investment approaches - with property and equities more valuable if inflation returns and bonds and cash favoured if the risk of deflation returns.

jd@intelligent-investor.co.uk

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

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