YIELDS ARE THE NEXT THING TO LOOK FOR, SAYS HENDERSON CHIEF ECONOMIST

Dr Shane Oliver, head of strategy and chief economist at Henderson Global Investors, was in town recently to give an update of global markets and the outlook for equities and bonds to investors. Below are some extracts from his 16 October 2002 article on "Strategic Allocation In A Low Return World" that provides some interesting views.

Be prepared for low returns
This could last for a decade, says Shane, as over the 1980s and 1990s, returns from equity and bonds were boosted way above long-term and sustainable averages. The adjustment from high to low inflation meant that capital gains from bonds and equities fed soaring equity prices which were not in line with corporate earnings. Today, this adjustment has run its course.

Higher returns were achievable 20 years ago because price-earnings multiples were low consistent with high inflation. This is not the case now, and PE multiples have already adjusted to the move to low inflation.

The collapse of communism in the late 1980s meant that defence spending was reduced. This freed up resources for use by the private sector. But this is now subject to some reversal with the US boosting its defence budget in their battle against terrorism.

Single digit returns expected
With significantly lowered bond yields, bond returns will also be in line with it, at around 5% or less.

Equity markets are likely to return around 8% with Australia, the UK, and Asia likely to come in slightly above this, and the US, Europe and Japan slightly below 8%. Countries with relatively high dividend yields, like Australia and UK, and/or strong growth prospects (eg: Asia ex-Japan) should do relatively better.

Property, listed or unlisted, should do relatively well because it provides rather high yields of 7% or so.

High-yield investments will be favoured
The coming decade is likely to favour investments underpinned by high yields rather than potential capital growth. We have already seen this through the recent downswing in equity markets, but it is likely to prove more than just a cyclical phenomenon.

The rise of other markets other than the US
The coming decade is also likely to favour markets other than large Western equity markets at the centre of the 1990s bull market, which is now subject to investor skepticism and loss of confidence. Corporate governance issues have also dogged US markets, and more bad news could emerge on that front.

Suggested strategic asset allocation
Increase exposure to non-US markets within global equities. Asia (ex-Japan) equities have a higher growth potential then US equities, as they are at the tail end of a secular bear trend which started in 1993.

Have exposure to small-cap equities. These stocks may have underperformed their blue-chip brethren during the US/large cap driven bull market in the 1990s, but they should outperform over the next 10 years. Small caps also provide greater scope for active managers to add value.

Increase exposure to a portfolio of properties managed by a fund manager or via a syndicate. Global listed property investments also offer high yields with diversification benefits, and they trade at a discount to net asset value.

Lower your exposure to government bonds in favour of property/corporate debt and cash. The low government bond yields suggest low returns from bonds in the future. Investing in higher-yielding corporate bonds or property may be better, and to offset risks, cash levels can be simultaneously increased. The return premium over cash is not likely to be high in the coming decade with bond yields at low levels currently.

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We also caught up with Shane for a chat. He highlighted the fact that this current rally in the US markets, since early October this year, could be the start of a bullish trend after reaching a bottom. His observations are derived from a four-year cycle that US markets seem to go through.

According to Shane, it takes about four years to reach bear market lows. Going back to the 1920s through to 2002, the S&P 500 index has shown a rather consistent pattern of coming to a bottom in a four-year wave. For instance, the index bottomed in 1962 and in 1966. The same happened in 1994 to 1998. In 1998, the collapse of hedge fund manager Long Term Capital Management sparked off a series of negative repercussions in the markets. "If the four-year cycle is to continue, we should be seeing the low point this year", which will be more than welcome after the pounding US markets have received.

The current rally may be seen by some as a short-covering rally, or because the market has been too oversold and it is now staging a technical rebound. But Shane believes that there could be more upside to come still. The US President is coming to his third year of presidency. The third year is usually more positive for the economy because the president will try ways to stimulate the economy so as to get re-elected for another term in the fourth year. There are exceptions, like the Great Depression in the 1930s, but this trend has been quite consistent over time, Shane noted.

Equity valuations have become more attractive vis-à-vis bonds, and Henderson recommends that investors keep a slightly overweight position in equities, and look to add further if stocks get cheaper.

Asia Pacific equities is still the place to be as growth potential in this area is highest. The Asian crisis in the late 1990s has weeded out weak players to a large extent, and structural reforms that were implemented have had some success. Asia Pacific equities are generally trading at a 30% price-to-book discount compared to global equities, says Shane. Within Asia, North Asian markets like South Korea and China are attractive. In Southeast Asia, Singapore, Thailand, and Malaysia are singled out as markets that investors should have some exposure to.