Australia’s powerful investment returns have been driven by the rising terms of trade throughout the commodities boom and generally low rate of inflation. But have the good times gone? Robert Hogg, senior consultant at Frontier Investment Consulting, assesses how major forces determining the performance of domestic asset classes will influence returns in the years to come.

Australian asset classes have boosted superannuation fund returns over the past decade. This makes it instructive to look at what factors have driven these returns historically, and what this means for likely future returns in domestic equity, fixed income and bond markets. Australian equities Australian equities had a stellar run versus international equities over the past decade, and it is well known that the key factor driving our market has been the very robust performance of Australian resources companies. This performance has been underpinned by the sharp increase in Australia’s terms of trade, led by Chinese demand for Australian resources, and the related sharp increase in the prices of bulk commodities such as iron ore and coal (see figure 1).

The increase in Australian exports to China has had a significant impact on the relative importance and profitability of the companies involved. Indeed, of the S&P/ASX 200 Accumulation Index’s 163.3 per cent return for the 10 years to 31 December 2010 (not annualised), BHP Billiton contributed 27.2 per cent, while a holding of BHP Billiton, Rio Tinto and Woodside Petroleum contributed 39 per cent. These individual stock contributions to the market’s overall return were broadly in line with individual underlying earnings trends: for every year over the past decade, the earnings produced by BHP Billiton (or occasionally Rio Tinto) have made the largest single contribution to the market’s overall earnings. Disaggregating the impact of dividends, earnings growth and change in price/earnings (P/E) valuations on total market returns across the entire market shows that earnings have contributed positively to its overall return in each of the past five decades.

Meanwhile, the impact of changes in P/E valuations has varied, with changes in this ratio negatively impacting overall returns in the past decade (and through the 1970s). But the contrast with the US market over the past decade is striking. While both markets have suffered from P/E compression – a falling P/E ratio – over this period, the Australian market was still able to post a positive return, boosted by the powerful performance of earnings. Australian bonds and cash Over the past 20 years, the return from Australian government and corporate bonds was in the high single digits, with similar returns produced by offshore markets. Meanwhile, trends in Australian inflation have driven the returns from domestic bonds and bank bills: since domestic inflation has trended lower over the past 20 years, yields on both Australian bonds and cash have also trended lower (see figure 2).

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