Investors of all kinds need to know what percentage of their portfolios can be spent each year with prudence and sustainability. The issue is clouded by the fact that since 1982, the returns on almost any portfolio have been gratifying and this experience has encouraged an expectation that is now difficult to justify. Before describing future returns, it is worth dwelling on why the returns of the past 16 years have been so good. At the beginning of that period inflation was in double figures and to fight inflation the world had followed the lead of Paul Volcker in the US and imposed high real rates of interest. Nominal rates of interest, both short and long term, were therefore at extremely high levels. Partly because of that, price earnings ratios were very low. Corporate earnings themselves were towards the bottom end of their range as a percentage of GNP. The stock market was therefore on a low multiple of low earnings and had a dividend yield of over 5%. By the end of 1998, all these had reversed. Inflation in the UK was modest at 2.5% and lower still elsewhere, real interest rates on index-linked bonds were down to 2% and long gilts yielded 41.4%. Partly as a result, price-earnings ratios soared to over 20 times and profits moved to the high end of their historic percentage of GNP. The stock market trades on a high multiple of high earnings and further re-rating is unlikely. Returns from here are likely to be materially less attractive than in the last two decades. On a sustainable basis, investors can spend the real return on their portfolio after expenses. The real return achievable depends on risk tolerance. The least risky asset in this context is not cash but long-term index-linked gilts. Ignoring a tiny re-investment risk, the gross real return is 2.1%, almost regardless of inflation. That can be enhanced by the assumption of currency risk. The long index-linked government bonds of the US and Sweden offer yields of 4.1% and France 3.4%, but only for 10 years. Purchasing power parity theory suggests major differences in the inflation rate in those countries and the UK will be reflected in the exchange rate, providing the current rate is in equilibrium. Fortunately, sterling is not undervalued. Cash returns offer a comfortable 2.5% real rate currently (5% - 2.5% RPIX). These returns have been high in the UK as monetary authorities have resisted inflation, but the promise of the governor of the Bank of England to be equally vigorous in sustaining inflation at the target level (currently 2.5%) suggests real rates could fall to 1% or less in weak parts of the cycle. The long-term average will probably be about 2%, 0.5% above the average for the last 80 years, but with greater risk than in index linked. Gilt yields are about 4.8%, 2.8% above our central expectation for long-term inflation of 2%. Projections are complicated by the possibility (or even probability) that the UK will join the Euro in 2002/3. That might lower the inflation expectation by perhaps 0.5%, raising the central projected real yield to almost 3%, in line with long-term historic averages for this asset class. The expected variation around these central cases, however, is substantial. Few will need reminding of the prolonged bear market in gilts ending in 1974. Equally, dramatic outperformance is possible if fears of deflation were to prevail. Then the real yield would exceed the 4.8% nominal redemption yield and significant capital gain is likely. However, central banks would do their utmost to avoid outright deflation and seem certain to succeed before too long. The central expectation of long-term returns therefore remains at 3%. UK equities are more of a conundrum because the current valuation looks rich in relation to history, even allowing for low inflation and interest rates, and a reversion to historic averages for dividend yield, price earnings or price-book values would be painful. In the very long term, the best guide to real returns is a function of the current dividend yield (2.4%) and the sustainable real growth in dividends. In the UK, that growth rate since 1918 has been about 2.2%, but this looks to have been boosted by the low cost of bond and bank finance through unanticipated inflation. In the US, the figure for dividend growth over long periods is 1.2%. It is likely future growth in the UK will reflect productivity growth - perhaps 1.3% - and be less than growth in GNP (1.8%), because some portion of future profits will go to unquoted and, as yet, unformed companies. If the figure of 1.3% is used, then the very long term expected real return is 3.8%. This is a long way south of the experience of the past 80 years, of 8% real. The difference is reconciled in dividend yield, which averaged over 5% over the period compared to 2.4% now, and the re-rating of the market from a 4.8% yield to 2.5% over that period. Also, re-investing the income has given a benefit from market volatility that would not affect our calculation. Overseas equities provide diversification and therefore reduce risk. It is less easy to suggest they enhance expected long-term returns. Much the same can be said of overseas conventional bonds, although implicit real yields in Europe and the US do appear higher than in the UK. While an expectation of risk-free long-term returns would suggest only about 2% after inflation, a portfolio with a benchmark of bonds and equities should be able to produce something between 3.25% and 3.5% real return before taxes and expenses. From a long-term perspective, it seems reasonable for the beneficiary of a portfolio to withdraw, before allowing for taxes and costs, about 3.25% and 3.5% of its value each year without impacting on capital value. - Peter Spiller is a strategist at Cazenove Fund Management.
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