UBS: Get used to low returns from equities
One of the big questions dominating equity markets today is whether or not equity markets will produce a lower return than the historical average going forward after the impressive gains since the end of the financial crisis.
Historically, the S&P 500 has returned an average 9% per annum for the past 100 years as a mix of earnings growth, and higher equity valuations have pulled the market up. However, post 2008 there is evidence that real growth has slowed down on a trend basis. Long-term expectations of inflation have also fallen globally. Nonetheless, equity valuations have remained resilient during this period.
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According to research from UBS, most of the equity market gains since the financial crisis has been due to a big decline in risk-free yields. “For current valuations to make sense amid a secular decline in earnings growth, we estimate that the “implied discount factor” for equities has likely declined by about 4% on aggregate in the US and EU. Is this excessive? No, it is the mirror image of the secular decline in bond yields. More specifically, at least 75% of the drop in the equities discount factor is driven by a sharp drop in long-term risk-free rates” the bank’s analysts write in a Global Macro Strategy research report published at the beginning of September.
Bond yields remained depressed, or fall further into negative territory UBS concludes that there is no reason why current equity market valuations cannot be sustained. In other words, while most of the analysts on Wall Street are currently arguing that the S&P 500 is overvalued, UBS hints at the idea that the market could be fairly valued considering the current environment.
Get used to low returns from equities
Unfortunately, while the market would appear to be fairly valued when weighed against risk-free yields, the slowdown in real global growth and reduced long-term expectations of inflation will severely limit equity gains going forward. If the market is indeed fairly valued, only earnings growth will propel the index higher. UBS estimates that earnings growth is also likely to decline on average from pre-crisis norms of 10 to 11% to ca. 6 to 7% in Europe and the US. Therefore, we are likely entering a “new paradigm for stocks” according to UBS. What does this new paradigm look like, Japan is a real world example:
“Lower total returns. Risk adjusted total returns declined in Japan as the economy fist started sliding into stagnant growth in the 90’s. As Figure 22 shows, total returns were on average quite high in the 80’s and 90s (almost 9% p.a.), even accounting for the burst of the asset bubble. In the 20 years that followed, total returns have averaged 0.2% annually. At the same time, vol increased in the 90’s and has stayed high since.”