Can the good times continue to roll in equity markets?

12 July 2013 | Asset classes


peter-westaway  charles-thomas 

Dr Peter Westaway, Chief Economist and Head of Investment Strategy Group, Europe (l) and Charles J Thomas, Investment Analyst (r)

Equities should continue to provide long-run returns despite the uncertain outlook for economic growth.

Over the past four years, world stock markets have performed better than might have been expected given the anaemic background of low growth. This article explains why equity markets aren’t just driven by the real economy and how improving sentiment and the impact of global quantitative easing (QE) policies have helped to underpin risk assets.  We briefly examine the drivers of long-term equity market performance and ask the question:  can equities perform well from here even if growth remains subdued?

Strong equity markets, weak real economy
Since the end of the global recession, with the recovery that began in the summer of 2009, equity markets around the world have performed remarkably well. In sterling terms, annualised returns in equity markets since June 2009 in major developed markets such as the UK, US, euro area and Japan have generally been above their long-term averages, in the range of 8.5 to over 20% per year, although there have been periods of significant volatility along the way.

This generally positive equity market performance contrasts markedly with the underwhelming economic background in the developed world.  The euro area is in recession, output in the UK is still nearly 4.0% below its peak from five years ago and unemployment in the US remains elevated.  Japanese equity markets have surged this year, with significant volatility, despite the fact that there is little concrete evidence yet of an improvement in growth in the hard data.  At first glance, this divergence between the real economy and the financial markets seems odd.

The disconnect is subtle
In fact, a closer look at this issue shows that, across a range of countries and throughout recent economic history, there has been little correspondence between GDP growth rates and equity market performance. This superficially surprising finding has been demonstrated in the academic literature and more recently in Vanguard research.1   Trend economic growth effectively has no bearing on long-term equity market returns.  The reason for this is that financial markets are forward-looking and reflect expected growth outcomes, while economic data is normally backward-looking. 

Figure 1 demonstrates this point, comparing “expected” and “surprise” growth outcomes with equity market performance in the euro area since 1999.2  Figure 1a compares market returns to prior consensus growth expectations from the ECB’s Survey of Professional Forecasters. It shows a weak negative relationship, meaning that growth forecasts have little to do with subsequent market returns.  However, in Figure 1b, when comparing growth surprises to realised market returns, we see the intuitive moderate positive relationship that many might expect. The point here is that economic activity does indeed have bearing on equity returns, but it is the difference between the growth outcome and expectations that really matters. So information about changes in GDP growth is only valuable if an investor can buy into the relevant equities before that information is reflected in the price, which is very difficult to do.

Rising valuations have driven recent equity market returns
This partly explains why it is possible to have strong equity returns, despite low headline GDP growth rates; market participants were already expecting a weak growth outcome in most developed markets (the IMF’s October 2012 forecast for growth in the G7 economies in 2013 was a modest 1.5%).  But recent strong equity performance doesn’t just come from growth surprises driving up expectations for future earnings growth. Recent market performance has been much more driven by changes in the appetite for risk, probably boosted by the global impact of QE.

Figure 2 provides some evidence for this proposition, showing how the recent global equity price growth has been driven by changes in valuations rather than underlying fundamentals such as expected earnings growth.   In fact, we estimate that after this period of catch-up, global PE ratios are now close to their long-run averages, but what does this mean for long-run returns?


Valuation:  a good, if imperfect, predictor of long-term returns

Previous Vanguard research has demonstrated that valuation metrics (such as price-earnings or price-book ratios) are the best metrics available for providing insight into future equity market performance, although even valuation leaves much of the volatility in returns unexplained. 3  In Figure 3, we demonstrate this moderate relationship across the major regions of the global equity market, comparing initial price-earnings ratios with subsequent 10-year returns.  As the figure shows, valuations have a moderate negative relationship with future returns (lower current price-earnings ratios predict higher future returns, and vice versa).

However, there is considerable uncertainty in this relationship.  Indeed, current valuations across these major regions, reflected in the pink shaded area, have been consistent with a wide range of future 10-year returns in the past: from about 1% to over 20% annualised.    This represents a fundamental truth when it comes to equity investing:  future returns are uncertain.  Based on current valuations, our best guess might be to expect positive returns, but there is considerable uncertainty when it comes to this estimate.

Long-run expected equity returns look respectable but uncertain
To account for this uncertainty in equity returns, investors should be wary of paying too much attention to “point forecasts” for asset returns; we think it is much more informative to talk in terms of return distributions, taking account of all potential outcomes. Figure 4 shows our forecast global equity return distribution derived from the Vanguard Capital Markets Model(R), a proprietary asset return simulation tool that infers future return outcomes from current market conditions, including equity valuations (see Wallick, et al., 2010 for details).   It suggests that the most likely outcome for average annualised global equity returns over the next 10 years is in the 6-12% range. But there is a lot of uncertainty around this central tendency. Our model predicts there is nearly a 1-in-10 chance that equities could produce a negative annualised return over the next decade, and nearly a 1-in-6 chance that equity returns could fail to outpace inflation.  There are similar tails in the distribution of outcomes on the upside, representing a moderate chance for higher-than-average returns.

So while recent equity market volatility is perhaps unsurprising, talk of the death of equities certainly seems misplaced. In our view, equities are well placed to deliver respectable returns for investors, not necessarily every year, but over the long run.  But it is important to realise that positive returns in the equity market are not a sure thing, even over time periods measured in decades.  So while the good times seem likely to carry on in equities over the long term, there’s always a chance for bad times to emerge. That’s why a balanced and diversified portfolio of both equities and fixed income is likely to be the most appropriate approach for most investors.

1. For example, researchers at the London School of Business published a study in 2002 that finds no relationship between real per capita GDP growth and real equity market returns across developed markets from 1900-2000 (Dimson, Marsh, and Staunton, 2002). Recent Vanguard research replicates this work for developed and emerging markets from 1970-2012, with similar findings (Davis, et al., 2013)

2. See Davis, et al. (2013) for similar analysis from a US perspective. 

3. See Davis, Aliaga-Diaz, and Thomas (2012)

The value of investments may rise or fall and investors might not get back the amount originally invested.

Davis, Joseph, Roger Aliaga-Diaz, Juliann Shanahan, Charles Thomas, Joanne Yoon, and Ravi Tolani, 2013.  Stock market returns in a low growth world: the relationship between GDP growth forecasts and long-term market returns.  Valley Forge, PA: The Vanguard Group.
Davis, Joseph, Roger Aliaga-Diaz, and Charles Thomas, 2012.  Forecasting stock returns: what signals matter, and what do they say now?  Valley Forge, PA: The Vanguard Group.
Dimson, Elroy, Paul Marsh, and Mike Staunton, 2002.  Triumph of the optimists: 101 years of global investment returns.  Princeton, NJ:  Princeton University Press.
Wallick, Daniel, Roger Aliaga-Diaz, Joseph Davis, 2010.  Vanguard Capital Markets Model.  Valley Forge, PA: The Vanguard Group.