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Shares, property, bonds or cash?

Shane Oliver
22 May 2013

Cash and bonds have been the place to be over the past five years as a whole, providing higher returns than residential property and shares.

But as we all know, past returns are not a good guide to future returns and this is particularly likely to be the case for cash & bonds, given the fall in interest rates & yields.

Going forward, shares and to a lesser degree property are likely to be a better option for investors (depending of course on their individual risk tolerance) as global recovery supports growth assets and low yields hamper the returns from bonds and cash.

Introduction

For the past five years as a whole, bonds and cash have been the place to be, particularly if cash is taken to include bank term deposits. While yields on bank deposits have been single digit, at least they have been higher than the returns from both shares and residential property, which have experienced high volatility. Of course some shares and some property locations have done well but the broad experience has been poor as the global financial crisis and its aftermath have weighed on returns from growth assets.

This has led to a situation where investors have preferred cash as an investment destination over property and particularly over shares. According to a recent survey, 35 per cent of Australians nominated bank deposits as the wisest place for savings compared to 24 per cent who nominated real estate and just 6.3 per cent who said shares. Reflecting this, investor fund flows into bank deposits and bonds have been very strong, but flows into property and shares have been poor.


Source: Westpac/Melbourne Institute, AMP Capital

This flight to “safety” has been a world wide phenomenon, albeit the focus in other comparable countries has mainly been on bonds given near zero interest rates in the US, Europe and Japan. The trouble is that all investment trends end up getting pushed too far, eventually giving way to a reversal. We are likely now at or close to that point in the case of cash and bonds relative to growth assets like shares.

Historical experience

But first let’s look at the historical experience. After allowing for costs, residential property has provided a similar return over the very long term to shares. Both have provided far superior returns than cash and bonds. This can be seen in the next chart, which shows the value of $100 invested in each of Australian shares, residential property, bonds and cash since 1926.


Source: ABS, REIA, Global Financial Data, AMP Capital

Since the 1920s, residential property has returned 11.1 per cent pa after allowing for capital growth, rents and the costs of owning and maintaining a property and shares have returned 11.3 per cent pa after allowing for capital growth and dividends. While housing is less volatile than shares and for many seems safer, it offers a lower level of liquidity and diversification. Once the similar returns of housing and shares are allowed for there is a case for both in investors’ portfolios over the long term. By contrast, reflecting its liquid nature and low volatility cash has returned just 5.7 per cent pa since the 1920s. Bonds are in between with a 7 per cent pa return, consistent with their higher level of volatility than cash (ie a bond investment can lose money in a year if bond yields rise) but lower riskiness than shares and property.

Focussing on the last decade, shares also surprisingly come out well. Thanks to great returns in the 2003 to 2007 period, over the past 10 years shares have returned 9.1 per cent pa. This compares to 5.3 per cent pa from residential property, which cooled down after a huge surge in property prices into early 2004, and 5.4 per cent from cash and 6.4 per cent from bonds.

However, for the past five years equity returns have been negative reflecting the GFC and its aftermath, with this also weighing on property but bonds and cash have done well.

Return comparison, Australian assets

What’s the outlook?

The return from an asset is a function of the income flow or yield the asset generates and capital growth. Of course in the case of cash or term deposits the yield is all that drives the return. And on this front the return outlook for cash is looking less promising.

Over the last year the official cash rate in Australia has fallen from 4.75 per cent to 3 per cent as the Reserve Bank has sought to boost activity in areas like housing and retailing as momentum in the mining investment boom slows and inflation is benign. While this is not the only influence on bank term deposit rates it is the major one at least directionally. As a result, while term deposit rates of 6, 7 and even 8 per cent were available a few years ago they are now nearer 4 per cent, and falling. Given the softness in the domestic non-mining economy and the prospect for further RBA rate cuts term deposit rates are likely to fall even further. This means that the prospective return on cash is rapidly dwindling.

Similarly for bonds, yields are now very low. Bond returns are driven by the underlying income yield they provide when the investment is made (the higher the better) and capital growth. If bond yields fall bond prices move up at the same time resulting in a capital gain for investors. This is effectively what has happened over the past five years, which has seen Australian 10 year government bond yields fall from 6.3 per cent to currently 3.5 per cent (after hitting a low of 2.8 per cent last year) as interest rates fell and investors bought bonds as a safe haven. The decline in yields has effectively added around 2 per cent pa in the form of capital growth to the annual return from bonds, explaining why bonds returned 8.3 per cent over the last five years even though their yield was much lower.

The problem is that yields need to keep falling if the return from bonds is to be maintained at anything like the levels seen in recent years. But with bond yields around record lows, the global economic outlook improving and safe haven investor demand likely fading this is becoming less likely. In fact the greater risk is that bond yields start to rise as investor flows switch out of bonds and back to growth assets and money markets start to factor in an eventual monetary tightening. This will see the bond returns of recent years go into reverse as rising yields result in capital losses for investors. So a best case scenario would be a return equal to the current yield from bonds of around 3 to 3.5 per cent, but it could end up being much less if yields rise much. This may already be starting to happen with bond yields rising recently.

By contrast, residential property and shares already offer higher yields and will benefit as economic growth improves. House and apartment yields are running around 3.7 per cent and 4.8 per cent respectively, which are well up from their lows last decade. With mortgage rates well off their highs and likely to fall further, the residential property market appears to have bottomed out after falling since mid 2010 with a mild cyclical recovery likely over the next 12 months. However, on average, short term gains are likely to be limited to around 5-7 per cent as buyers remain cautious about taking on excessive debt, particularly as job insecurity remains high. More broadly, capital growth in residential real estate is likely to be constrained over the next five to 10 years by still very high property prices relative to incomes and rents and house prices still above their longer term trends. This suggests that a cyclical rebound in real estate prices over the next year should be seen as part of a broad range bound market for property prices in real terms as the market continues to work off the excesses that built up over the property boom that started in the mid 1990s and continued into last decade. Of course, good quality properties in sought after locations will do well, but the medium term back drop for property returns is likely to remain constrained, albeit better than that from cash and bonds.

There are two risks for property. The main downside risk is that China has a hard landing with the hit to export earnings resulting in sharply higher unemployment, forced sales and hence lower house prices. The risk of a hard landing in China seems to be receding though. The other risk is on the upside: there is always a concern that the old housing bubble is reignited by the latest collapse in mortgage rates. Again this seems unlikely though given Australians’ more cautious approach to debt since the GFC.

Shares are probably the most attractive asset. After a five year period of poor returns, despite the rebound over the last year, Australian shares are offering relatively attractive starting point dividend yields of around 5.7 per cent with franking credits added in. This is not to say that shares are in for a smooth run. Risks remain in the US and Europe regarding public sector debt problems, but they seem to be fading. However, with reasonable starting point yields (or income flows), only modest capital growth of 3 to 4 per cent pa is required to provide a decent return. If global growth continues this should be achievable. The main downside risk here would be if global and Australian growth slides into recession taking profits with it. This seems unlikely given how easy monetary conditions are. Counter to this there is always the possibility that the easy monetary environment really takes hold globally resulting in a huge surge in economic growth and investor flows back into growth assets. This would be very positive for shares.

The next chart also provides some support for shares. We all know that Australian shares fell over the past five years as a whole. But as can be seen rolling 5 year changes in Australian share prices tend to be “mean reverting”. Historically, whenever five year rolling capital losses have ever been as negative as they were over the last five years (ie in 1894, 1930, 1942, 1974 and 1992), the subsequent five year capital growth has been strongly positive (in fact with an average gain of 13.4 per cent pa). This points to solid gains in share prices over the next five years.


Source: ASX, Bloomberg, AMP Capital

Drawing this together suggests medium term (5 year) returns of around 4.5% pa or less for cash and term deposits, 3% or less from bonds, 5% pa from residential property and around 10% pa from shares.

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