June 2015
For professional investors only
Real Matters
The long & the short of it
Simon Doyle, Head of Fixed Income & Multi Asset
One of the questions we get most in talking to clients is: “why do we have a more positive view on Australian equities than
most other global markets?”. This question is usually in response to our 3-year return forecasts that shows indicative
returns for Australian equities of around 8% p.a. compared with just 2% p.a. for US equities and similar to lower numbers
for core Europe and Japan.
In answering this question we normally preface our response not to get too fixated on the precise numbers, as these really
represent a summary of a range of views around long run and short run factors influencing these markets that we have
“collapsed” into a return forecast. These factors help give us an idea of the likely quantum of returns across the asset
spectrum, the relativity of returns across markets, and importantly risk, but that these numbers tend to imply precision
which can be misleading. Over time though, this framework has provided a useful guide and has historically tracked actual
outcomes pretty well.
All that said why are our numbers for Australian equities tracking significantly higher than that of the other major global
markets?
There are broadly two reasons:
Firstly, our return forecasts are based on a combination of long run (7-10 year) factors overlaid with our cyclical valuation
framework. To assess longer run influences we assess all markets using three fundamental factors – yield, long run
earnings growth, and structural valuations. On this basis there are two key points of difference. The first is that Australia
has a significantly higher yield (more than double that of most other markets). The second is that Australia is closer to
longer run fair value, whereas the US market, by contrast, is trading on relatively extended longer run multiples. The
clearest example of this is in comparing the CAPE (cyclically adjusted PE) ratios for Australia and the US. Australia is
currently trading in line with longer run multiples of around 15 times (consistent with relatively normal future return
expectations) whereas the US is trading on multiples closer to 30 times, consistent with very low single digit returns over
the medium to longer run.
Secondly, based on our shorter run valuation measures the Australian market is again trading around fair value whereas
the US market, for example, is on the expensive side (albeit not ridiculously expensive). Why is this? Well the US equity
market has been at the forefront of central bank stimulus for seven years (0% official interest rates, multiple rounds of
quantitative easing, and aggressive and persistent central bank “jawboning”). When coupled with reasonable earnings
growth this has propelled the US market to extended multiples. However while earnings have been improving they are
arguably peak cycle, with the labour market also improving, the currency strengthening and funding costs potentially as
good as they get, margins are likely to moderate.
While the Australian equity market is not without its challenges – especially given the extended structural valuations in the
financial sector (even after the recent pull back in bank share prices), it has nevertheless underperformed global markets
over recent years as declining commodity prices have hit resource and energy producers and associated companies.
Arguably though, the market has already significantly discounted the downturn in the commodity cycle – hence valuations
look OK – not great, but OK. These views are reflected in the Real Return strategies in a number of ways.
Important Information:
For professional investors only. Not suitable for retail clients.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect
the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the
Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification,
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