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

Finacial products from our partners
Property search
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    SThree: Trainee Recruitment Consultant - Swiss Banking and Finance

    £20000 - £25000 per annum + Uncapped commission: SThree: Can you speak German,...

    Ashdown Group: Marketing Executive - 6 month FTC - Central London

    £25000 - £30000 per annum + benefits: Ashdown Group: An exciting opportunity f...

    Ashdown Group: Junior Project Manager (website, web application) - Agile

    £215 per day: Ashdown Group: Junior Project Manager (website, web application ...

    Guru Careers: Software Engineer / Software Developer

    £40-50K: Guru Careers: We are seeking an experienced Software Engineer / Softw...

    Day In a Page

    Fishing for votes with Nigel Farage: The Ukip leader shows how he can work an audience as he casts his line to the disaffected of Grimsby

    Fishing is on Nigel Farage's mind

    Ukip leader casts a line to the disaffected
    Who is bombing whom in the Middle East? It's amazing they don't all hit each other

    Who is bombing whom in the Middle East?

    Robert Fisk untangles the countries and factions
    China's influence on fashion: At the top of the game both creatively and commercially

    China's influence on fashion

    At the top of the game both creatively and commercially
    Lord O’Donnell: Former cabinet secretary on the election and life away from the levers of power

    The man known as GOD has a reputation for getting the job done

    Lord O'Donnell's three principles of rule
    Rainbow shades: It's all bright on the night

    Rainbow shades

    It's all bright on the night
    'It was first time I had ever tasted chocolate. I kept a piece, and when Amsterdam was liberated, I gave it to the first Allied soldier I saw'

    Bread from heaven

    Dutch survivors thank RAF for World War II drop that saved millions
    Britain will be 'run for the wealthy and powerful' if Tories retain power - Labour

    How 'the Axe' helped Labour

    UK will be 'run for the wealthy and powerful' if Tories retain power
    Rare and exclusive video shows the horrific price paid by activists for challenging the rule of jihadist extremists in Syria

    The price to be paid for challenging the rule of extremists

    A revolution now 'consuming its own children'
    Welcome to the world of Megagames

    Welcome to the world of Megagames

    300 players take part in Watch the Skies! board game in London
    'Nymphomaniac' actress reveals what it was really like to star in one of the most explicit films ever

    Charlotte Gainsbourg on 'Nymphomaniac'

    Starring in one of the most explicit films ever
    Robert Fisk in Abu Dhabi: The Emirates' out-of-sight migrant workers helping to build the dream projects of its rulers

    Robert Fisk in Abu Dhabi

    The Emirates' out-of-sight migrant workers helping to build the dream projects of its rulers
    Vince Cable interview: Charging fees for employment tribunals was 'a very bad move'

    Vince Cable exclusive interview

    Charging fees for employment tribunals was 'a very bad move'
    Iwan Rheon interview: Game of Thrones star returns to his Welsh roots to record debut album

    Iwan Rheon is returning to his Welsh roots

    Rheon is best known for his role as the Bastard of Bolton. It's gruelling playing a sadistic torturer, he tells Craig McLean, but it hasn't stopped him recording an album of Welsh psychedelia
    Morne Hardenberg interview: Cameraman for BBC's upcoming show Shark on filming the ocean's most dangerous predator

    It's time for my close-up

    Meet the man who films great whites for a living
    Increasing numbers of homeless people in America keep their mobile phones on the streets

    Homeless people keep mobile phones

    A homeless person with a smartphone is a common sight in the US. And that's creating a network where the 'hobo' community can share information - and fight stigma - like never before