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Long Term Growth: Changes to Likely Investment
Returns
Impact on Financial Planning Decision-making
by John Robertson (Reproduced from the May
2007 ATC Digest)
Hidden in the second
intergenerational report from the Australian government are some warnings for
financial planners about likely investment returns. These warnings also
contain some signals about the long-term attractiveness of resource sector
investing.
Most of the
emphasis in the government’s intergenerational report released on 3 April by
Treasurer Peter Costello was on the challenges of funding government spending
while faced with an aging population.
The growing
mismatch between people of working and non working age potentially creates a
burden on future taxpayers. They will have to fund their own spending. They will
also have to meet the rising demands from government for more revenue to fund
the needs of the growing group of residents who are no longer paying tax but are
reliant on more government services.
The full extent
of the predicament is not inevitable. Markets and institutions are often able to
adjust to changing circumstances. For example, encouraging people to work longer
by not retiring at 55 years of age is one way to reduce the burden on the
existing workforce. Greater recourse to immigration can change the outcome, too.
Nonetheless, the
base case for the Australian economy is a slowing rate of population growth and,
with that, an impact on overall rates of economic activity.
The Sources
of Growth
GDP growth can be viewed as a combination of:
Long term
forecasting of GDP is only as accurate as the forecasts for each of these three
factors and, to that degree, our anxiety about a slowdown in growth might prove
misplaced. Equally, we might be underestimating the full impact of what is going
to happen if productivity growth falls short, for example.
On the reckoning
of the Commonwealth Treasury, however, GDP growth is likely to slide from an
average of 3¼% a year over the past three decades to something closer to 2% over
the coming four decades. This decline is illustrated in the accompanying chart
with data from the Treasury report.
Since business
profitability reflects economic conditions, the Treasury prognosis for a
slowdown in GDP growth also implies lower investment returns.
Slower Growth
Means Weaker Investment Returns
Economy wide profit growth rates are a function of output growth and price
changes. Put simply, if output grows by 5% a year and prices and costs both
increase by 5% a year, profit growth is going to be (slightly more than) 10% a
year. In theory, the increase in profit will be 10% plus .05 x .05 or 10.25%.
In Australia,
since the beginning of 1960, the rate of increase in corporate non-financial
gross operating surplus, as published by the Australian Bureau of Statistics in
the national accounts, has been 10.0% a year. During that same period of time,
the average annual rate of increase in output has been 3.6% and the average rate
of price increase has been 5.5%.
The difference of
0.9 percentage points could be thought of as coming from other factors including
some ability to keep cost inflation below the rate of output price inflation (as
well as some measurement error).
The environment
ahead of us will be radically different.
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Firstly, there is the possibility highlighted in the
intergenerational report of output growth trailing off to 2% a year.
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Unless there
is a failure of policy, given the objectives of the government and the
Reserve Bank, the rate of price increase is likely to be around 2.5% a year
over the longer term.
These two
outcomes imply profit growth of just 4.5% a year, less than half the rate of
increase which Australia has experienced historically.
Less Scope for
Offsets
This scenario would mean correspondingly lower returns from investments in
locally based companies unless there were potential offsets from other sources.
However, the offsets which one might normally anticipate seem less likely in the
future.
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The possibility of an offsetting reduction in interest rates
to support asset values will be limited by the rising borrowing requirement
of the government as it strives to cope with the fiscal impact of population
aging.
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The
possibility of favourable funds flows into Australian markets supporting
security values might also be limited by withdrawals from historical savings
only partially being offset by new savings.
Breaking the
Historical Mindset
Investment strategists have been saying for several years that we cannot expect
future investment returns to duplicate what we have seen recently. The full
impact of that observation has probably not been absorbed by investors as
markets have continued to rise well above the expectations strategists have been
trying to create.
In any case, it
is always difficult to know when the short term finishes and the long term
begins.
Whatever the
answer to that question, the best guess from our most skilled forecasters (i.e.
those in Treasury) means the emergence of a radically different environment for
financial planning.
One message from
the intergenerational report is that any financial adviser will need to cut
himself off from the history with which he is most familiar. He will need to
ensure that his advice is not biased by economic outcomes which are no longer
relevant for lifetime planning purposes.
A Different
View of Resources
In trying to do this, and in looking to boost investment returns, the relative
attractiveness of Australia’s mining sector should loom larger.
This is one
sector of the economy whose growth (and investment) potential is not tied to the
decelerating Australian economy.
Prior to the
current cycle, returns from resource sector investments had been poor.
Generally, their economic circumstances had been dictated by conditions in the
advanced economies which were also reflected in the pattern of Australian
growth.
The 1960s to the
1990s generally favoured domestically oriented companies as Australia’s
long-term domestic growth potential was at its height.
Basing one’s view
of appropriate sectoral exposure for the next two or three decades on what
happened in the 1990s or 1980s might be a trap for the unwary which fails to
take adequate account of these important structural changes.
John Robertson is a member of the E.I.M.
Capital Managers investment committee. He provides economic and investment
analysis to the financial services industry through thebigpicture
Economics. His economic and investment commentaries appear in the weekly
AllThingsConsidered email (see www.atcbiz.com.au) for financial
planners and the monthly ATC Digest, available free of charge to
FINSIA financial advising special interest group members and by subscription to
others.
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