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Future Returns Debate

Part One: “Here is the Forecast - Moderate, Rising More Slowly”

The art of debate and discussion is alive and well at Equilibrium Asset Management.  When it comes to decisions about investments, no-one has the perfect crystal ball and thus all worthy contributors are welcome.

At a recent Investment Management Committee meeting my vote indicated that I expect investment returns to be around 3% lower than the long run average of 10% over the next 18 months.  This blog explains the reasons why.  

Next week’s blog will be from Mike Deverell who will explain why he believes the market outlook is much brighter. 

Tamed Bull

Let’s get one thing clear from the very start.  I’m a bull.  Cut me in half and I’m through and through an equity optimist.  However, and here’s the rub, my outlook for the returns from equity markets has moderated such that I think we will get around 7% over the next couple of years instead of the 10% historic average.  

Why?

I am a rational rather than a seat-of-the-pants, gut-feel sort of investor and so will give you three good reasons for my thinking;

The Great Moderation

Firstly, if we look at the UK stockmarket and assume at 6,400 it is about fairly valued, (it’s been around this level now for around a year), what is going to drive future growth in the market?  Profits growth.

OK, let’s see how that breaks down.

Over the very long term in the UK, inflation has been around 5.5% and real GDP growth has been 2.5% giving a total growth in the economy of 8% (5.5%+2.5%).  Now, this is for the whole economy including many areas of government that have been less productive than average.  So, if we add-in the average private sector labour productivity of 2% to 3% gets us to the long run average returns on the market of about 10-11%;  

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Fair enough. But where are we now?

Well, inflation is currently much lower and expected to remain so.  Being optimistic, I expect real GDP to hold up but the key issue is the ‘productivity puzzle’, or growth in output per head, which has been almost zero recently.  Being generous, let’s say it picks up (but below the historic norms) to around 1.5-2.5%.  Thus, I get to the outlook for around 6-7% profit growth and market returns over the next 18 months;  

table2.png

Overpaid

Secondly, over the long term dividend income has been around 40% of total market returns.  The current dividend yield on the market is around 3.5% so shouldn’t total returns be around 10%?  

Well, no.  Companies are paying out too much in dividends such that the dividend cover (earnings per share divided by dividends) is at an all-time low.  Already this year a number of FTSE companies like Tesco and Centrica have cut their dividends and many large companies are still paying dividends out of debt or in the form of shares.  This points to either the market dividend yield falling or being static for some time.  

I will spare you the maths but if we were to adjust the dividend yield to the long term pay-out ratio this would get us to around 2.8% yield which, hey presto!, would be 40% of a total return of around 7%.

Fairly Valued  

Lastly, this valuation metric is not alone is pointing to a reasonably full valuation on the stock market.  If you look at any of the mainstream valuation measures like historic and forecast P/E’s, price to book and price to cashflow, they all tell the same story.

In summary, the outlook is still good.  Growth continues to tick along but equally we have come a long way since the dark days of 2008.  We are up 125%, or nearly 12% annualised, over that time and I believe future returns will moderate.  

We’ll all continue getting richer but maybe just a little slower.  
 

The content contained in this blog represents the opinions of Equilibrium investment management team. The commentary in this blog in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader.