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The search for yield

25 November 2016, Wealtheon

Written by Rob Derkx - Wealtheon Eindhoven

Risk and reward go hand-in-hand: we've known this for centuries, and it certainly comes as no surprise to any seasoned investor. Both risk and reward are constantly influenced by essentially uncertain factors, which is why they are constantly subject to analyses and forecasts, used by investors to guide their strategic decisions and investment tactics.

In a bid to predict long-term returns on equities, investors rely on economic growth which, in theory, is predominantly determined by the volume of the working population and by work productivity growth. In other words, the younger a country's population, the more members of the population are working and the higher the probability of economic growth...and vice-versa.

Work productivity also depends on a country's demographic structure, combined with the innovations adopted by its businesses.

With that in mind, it's interesting to note that the world population is still growing by around 80 million per year, i.e. by approximately 1%. Setting aside the question of whether such growth is sustainable, it means the world holds economic growth potential of about 1% per year.

If we consider that work productivity also has the potential to continue climbing, as it has for the last 100 years, we can add another 2% in global economic growth. Annual global economic growth of some 3% is ample fodder for equity yield. In fact, this figure is not far from current forecasts for the years to come, though slightly below the multi-year average of 3.8%.

Admittedly, this is a fairly rough analysis. Even so, it gives us a foundation to explain today's prevailing economic trends. Western countries, led by the United States, Europe and Japan, are all dealing with an increasingly ageing population. In Japan, the phenomenon even recently led to the first ever population decrease in the country's history. Meanwhile Asian, Latin American and African emerging countries have a young population, responsible for the lion's share of the world’s population growth. The logical result is that, for now, emerging markets account for 70% of global economic growth and are thus naturally claiming an increasing share of global wealth. This trend is poised to grow stronger in the coming years.

Investors could understandably come to the conclusion that they need to adapt their investments to this trend by investing much more of their capital in emerging markets. The argument seems sound enough. Nevertheless, these financial markets are well known for their inconsistency and high risk. So what has experience taught us?

From a risk distribution standpoint, there is little added value to be had investing in emerging equities due to their high correlation with Western stock markets. Share prices follow the same trend; only results are higher overall on emerging markets. Consequently, investing in these markets increases potential returns, but also exposes the portfolio to greater risks.

What's true for equity investments is also true for bond investments, to a certain extent. The perpetually low interest rate environment has sent bond investors on a never-ending quest for alternatives to high-quality European and US securities. They too must make a choice on whether or not to assume the additional risk associated with these alternatives.

And what to make of the increase in direct investments in real estate, private equity funds, mortgages and loans on the parallel market? As a general rule, such investments are less liquid and thus make it harder for investors to unwind them quickly. Meaning they will want a higher yield to compensate for taking on this additional risk. Interestingly, a growing number of institutional investors (traditionally cautious, as the majority consist of pension funds) are turning more of their attention to this less liquid investment category.

The search for yield will never stop, and where there's growth, investors will naturally follow. When in 1988 the benchmark Morgan Stanley World Index (MSCI) added is first emerging market position, it represented a mere one percent of the world's market capitalisation. This 1% has since shot up to 14%, driven by the solid economic development of countries such as China, India and Brazil. This trend is even expected to accelerate now that EM countries are opening the door wider to foreign investors.

For investors not yet ready to take the leap: many companies listed on the US and European stock markets generate a fair percentage of their revenue in emerging markets (including Pepsico, Starbucks and Google).

For now, emerging markets clearly still play an important role for many investors.



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