Rumble or roar: the future for global equity markets
In the first of two articles, we look at three possible scenarios that could unfold in global equity markets over the next five years - are the roaring 20’s upon us, or is there reason to tread more carefully as we head into the next decade?
There are three main possible outcomes in markets over the next few years: a recession, the bull-market continues or the status quo.
Money supply and the cost of money is a big driver of equity markets - and this is one reason why they made such strong progress in the first half of 2019.
Assuming no major recession in the next five years, the most sensible prediction for equities is that they perform in line with company profits growth; modest but positive.
Looking backwards to move forwards
Past performance is not indicative of future returns, but lessons can be learned from historic market events to help investors to take a forward-looking view. The last few years have been good for equity investors - It’s been a bull market and one that has been led by the US.
Since the start of 2012, the US market (S&P 500 Index) has more than doubled (up approximately 170%, including dividends), while the MSCI All Countries World Index is up 75% (around 110% on a total return basis) in US dollar terms. Valuations have not changed that much, which means that the world, as a whole, is valued (against the current earnings base) at roughly the same level as it was five years ago. Technology has produced the best earnings and the best performance but has become more expensive. Conversely, slower growth areas (financials, industrials and materials) have become cheaper.
More recently, fears of impending recession have caused more money to move into perceived lower-risk high quality companies. The premium for “quality” has risen to levels never seen before, particularly in Europe.
What does the next five years hold for equity markets?
Given that markets are not that far from long-run average valuation levels in relation to current earnings (and are cheaper than 30-year averages on free cash flow valuation), probably the most sensible prediction is that equity markets perform in line with company profits growth. This will be fairly modest but should be positive if we assume no major recession in the next few years.
The longer one’s time horizon, the more important earnings growth is in explaining market moves. However, over shorter periods, other factors introduce greater volatility that overwhelms the impetus from earnings (in either direction). In particular, money supply and the cost of money is a big driver - and this is one reason why markets made such strong progress in the first half of 2019.
It is helpful to consider three possible world scenarios for the next five years.
Under the first, we see recession and a fall in corporate profits. Under the second, markets rise significantly on a combination of higher earnings and higher valuations. Under the third, there is little if any earnings growth and markets stay roughly where they are. Whilst the middle path is the one that seems to make most sense to plan for, it appears that the “melt up” scenario is more plausible than the “collapse” case.
Scenario 1: Recession?
Although it is difficult to quantify the risks of a major geopolitical incident, a significant economic downturn seems unlikely in the next few years. In the past, classic recessions were caused by overinvestment and declining industrial returns but there is no evidence that economies have been adding too much capacity. (Indeed, healthy profit margins in many industries are evidence of this.)
Equally, a recession caused by a stressed banking system seems also highly unlikely given that around the developed world banks have rebuilt capital and a large part of the riskier assets have been removed from balance sheets and are now held by hedge funds and other investors.
A more likely recession scenario is the “Japanese style” recession that we have seen a number of times in the past 30 years. These are short-term downturns, often caused by industrial inventory cycles, that are met with monetary stimulus and government spending initiatives. This can lead to opportunities to pick up oversold stocks at the gloomiest moments.
Scenario 2: The Bull market continues?
As monetary policy remains loose (and may ease further) and it is highly likely that governments will step up spending to mitigate economic softness, there is a reasonable chance that markets rise to higher valuations. After all, the last five years have seen markets rise despite investors taking money out of equity mutual funds.
Now that equities provide a dividend yield that is significantly higher than government bonds and offer some potential inflationary protection, maybe investors will allocate more to equities in the next five years. A major “melt up” in markets cannot be a central case but could be argued to be at least as likely as a major correction.
Scenario 3: Status quo?
In the more likely scenario of low global growth (lower than the past few years due to geopolitical and trade uncertainty), earnings can be expected to grow at a modest pace. Free cash flow is a positive and should continue to drive share buybacks which in turn augments underlying growth in earnings-per-share.
In this relatively low growth scenario, we should also expect periods of volatility in markets. Rather than trying to avoid them entirely, we should be ready to look for opportunities that will be thrown up along the way.
In part two of this piece we outline six key themes that we believe investors need to consider over the next five years and discuss how these issues could shape and impact market leadership from here.