I said recently that the outlook for equities is good. What I didn’t say, though, is that this is a short-term prospect caused by investor sentiment today being unusually low. We’ve good reason to fear that the longer-term outlook for the market is poor.
One reason to fear this is simply that expected returns on gilts are low: longer-dated ones have real yields of -2 per cent. This means that equities can only do well if they offer a big premium over gilts.
But do they? My chart suggests not. Each point on the line shows the difference between annualised returns on equities and gilts since the date on the horizontal axis – so, for example, since December 1989 equities have outperformed gilts by 0.5 percentage points per year. It’s clear that, for most of the time, the equity premium has been low. It is only after they have been unusually cheap that they’ve offered a decent premium – such as after the tech crash or at the worst points of the financial or eurozone crises.
Luckily, the fact that the dividend yield is above its long-term average does indeed suggest equities are cheap: the yield has been a fantastic predictor of the equity premium on the past. But this only points to equities out-performing gilts by around two percentage points per year. With real gilt yields negative, this implies low real returns on shares.
In theory, such a prospect should not be surprising. Back in 1985 Rajnish Mehra and Edward Prescott showed that, in theory, equities should not outperform bonds by very much. And indeed, since they wrote that they have not done so. This could be a good example of how investors wise up to past mispricings: having learned from Mehra and Prescott that equities were traditionally underpriced, they piled into them in the mid-1980s, raising their prices to levels from which returns have been only moderate.
Our expectations, however, are not much shaped by high theory. Instead, research shows that they are influenced by experience in our formative years. For many of us, these years – the 1980s and 1990s – were a time of soaring share prices, and so we've come to expect high returns.
In truth, though, that experience might be misleading because returns then were boosted by three factors that might now be disappearing.
One is the political climate. Margaret Thatcher and New Labour, and Bill Clinton, all agreed upon one thing – that the role of government was to provide a stable framework in which businesses could plan. This consensus has now been broken: Brexit and President Trump’s trade wars mean that governments now introduce additional uncertainty into the economy. This matters because political uncertainty reduces share prices: there’s a strong correlation between uncertainty and equity valuations. This means that if uncertainty remains high, share prices will stay low.
A second factor is inflation. As this fell in the 1980s and 1990s, so too did real interest rates because central bankers no longer needed tight monetary policy to fight inflation. This boosted share prices because it reduced the discount rate applied to future real earnings without reducing those earnings.
This was, though, a one-off factor. If inflation falls further it is likely to hurt shares by increasing fears of deflation.
Thirdly, the 1980s saw a shift in incomes from wages to profits – a process that has continued in the US but not the UK. New York University’s Sydney Ludvigson and colleagues show that this – much more than economic growth – was the main reason why US shares rose so much after 1980 – and this dragged up UK prices too.
All this suggests that longer-term returns on equities might well be lower than in the past simply because some of the things that boosted them in previous years will cease to do so.
Something else supports this pessimistic view. It’s simply that labour productivity is stagnating: it has risen only 0.2 per cent per year since the end of 2007 compared with 2.3 per cent per year in the previous 30 years. This matters simply because equities are a claim to a slice of the economic pie. And if the pie isn’t growing much, the value of such claims is unlikely to rise much.
This doesn’t mean we are destined for a permanent bear market. Japan’s experience after 1990 shows that bad long-term returns are wholly consistent with the occasional bull market. But it does mean that, over the long haul, average returns might be worse than we expect. For those of us hoping to draw down our wealth in retirement, this is an especially scary prospect.