The ‘Golden 90s’ for equities are definitely over. In the mean time, most investors have recognised that the sooner we put the past decade behind us, the better off we will be at the end of the next decade. Equity markets across Europe have fallen sharply over the past two years since the peak of the technology bubble in March 2000. Currently, investors are still uncertain about the economic outlook.
So investors are faced with the question: what comes next? The answer to this question is in two parts. First, what can we reasonably expect to earn with equities over the next 10 years, and, second, what is the short term outlook?
To answer the first question we need to look in the past and try to understand where the equity performance in the past had its roots. An equity owner earns the dividend yield and the price appreciation of the stock he owns. The price appreciation itself can be decomposed into a growth rate of stock valuation as measured by the price-earnings (P/E) ratio, a growth rate of real corporate earnings and inflation. The table shows the sources of the European equity return over the past 32 years based on MSCI data. Looking at the full period, it is clear that more than 50% of the annually compounded 12.2% equity return can be explained by the high inflation across Europe, especially in the 1970s. Real earnings growth contributed only a small share to total performance, followed by an average annual P/E growth rate of 0.8%. The table also highlights the importance of dividends as a source of equity returns.
The picture is different over the past 11 years. The average annual inflation and also the dividend yield is lower than for the total period, whereas real earnings growth contributed 1.9% to the total equity performance. Real corporate earnings growth matched average real GDP growth in Europe of 2.1% almost perfectly over this 11 year time period. But the largest piece of the return can be assigned to an annualised P/E growth of 3.3% which contributed almost 30% to total the overall equity performance of 11.2% a year. The picture would have been even worse for the 10 years ending 2000. Almost 45% of the total equity return of 18% from 1990 – 2000 stems from a valuation change as measured by the P/E ratio.
Let us suppose that 10 years from today we look back and analyse the equity return we will have earned in the same fashion. What is the most likely scenario? The dividend yield on the MSCI Europe Index is at present 2.3%. There is no obvious reason to assume a much lower or higher average dividend yield over the next 10 years. Real earnings growth is naturally linked to real GDP growth. Given the current economic outlook, it seems, even in a very optimistic case, unlikely that firms on aggregate will be able to increase their real profits by much more than 2.5% on average over the next 10 years. European inflation rates have decreased almost continuously over the past 32 years. The current level of approximately 2 to 2.5% annual inflation leaves little room for further decreases. On the other hand, it seems unlikely that inflation rates will increase sharply which would paint an even more negative scenario for equities.
Finally, valuation levels as measured by the price-earnings ratio have normalised over the past two years. If we rationally assume that valuation levels remain unchanged on average and if we sum the above figures, we end up with a forecast for equities in a range between 6.5% and 7.5%.
Of course, all this is not a rigorous economic analysis. Rather it allows some interesting insights and provides some feeling about the direction of the equity returns in the future. The conclusion is sobering. It seems that equity returns over the next 10 years are most likely to be much lower than what investors were used to in the ‘Golden 90s’, unless we saw some very extreme scenarios – for example, extraordinary profit growth. This has important implications for any strategic asset allocation decision.
Our short to medium term outlook is based on our quantitative European tactical asset allocation (ETAA) model that evaluates macroeconomic, valuation and technical factors to forecast returns on European equities and bonds. We currently hold a neutral weighting of European equities compared to European government bonds in our balanced accounts. The improving economic data, together with the meanwhile sound valuation of equities compared to bonds, have caused us to decrease the underweight in equities since the beginning of the year.
Andreas Sauer is managing director and chief investment officer at
DG PanAgora Asset Management in Frankfurt