The forecast for global growth has yet again been downgraded, this time by the International Monetary Fund (IMF) to 3.3%, the slowest pace of growth since the global economy shrank during the recession in 2009. This downgrade by the IMF includes the Canadian economy, which, due in part to lower oil prices, is now expected to grow at 1.5% in 2015 (down from 2.3% at the beginning of the year). Even forecast U.S. growth has been cut to 2.5% from 3.1%.
With such a backdrop, combined with the political theatre that played out between Greece and the European Union, it seems like an opportune time to revisit the prospects for equity market returns.
There has been a large disconnect between the global economic recovery and equity market returns. Developed equity markets now stand above pre-crisis highs and credit markets have seen their spreads fall substantially. Even with the most recent market corrections, savvy investors have made a lot of money over the past few years.
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Over recent years, global equity returns have been strong. This was initially driven by strong aggregate growth in corporate sales and earnings since the financial crisis of 2008/9. However, in recent years, returns have been driven by a re-rating of fundamentals: a compression of forward-looking risk premia.
To value equities, one has to understand the level of earnings growth discounted by current market prices. Over the past 10 years, the discounted long-term earnings growth for the S&P 500 has ranged from 3% to -2%. Currently, discounted earning growth remains low relative to the past five years. At the end of 2013, the real implied earnings growth rate was 2.6%. This fell to 1.1% at the end of January 2015, and has since rebounded to 2.2% as at June 30, 2015.
Despite years of deleveraging, high debt levels (both government and household) imply that major economies and individuals remain near their credit limits. This will likely continue to constrain economic growth, the level of interest rates, and with it inflation. The expected return for equity markets over the next few years under this scenario is about 5% annually as corporations generate low, but positive real earnings growth.
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The impact of low inflation will depend on whether corporations can hold prices, or are forced to pass cost deflation onto consumers, as has been the case in the European retail sector over the past few years. As well, there’s the potential for wage pressure in the U.S. to erode corporate profit margins.
A more optimistic outlook would have equity markets returning 8.5% annually over the next few years. Under this scenario, productive debt financed spending adds between 0.5% and 1% to global growth. Interest rates and inflation both increase but as the result of the improving economic fundamentals. Corporations are able to capitalize on the improvement and as a result, realized earning growth would be above trend. It’s worth noting that this scenario is much less likely than the continued indebtedness outlined above.
Given the level of geopolitical risk and the risk of deflation, it would be remiss not to explore a more negative environment than the present and its implications. While Greece and the European Union have negotiated a tentative détente, there remains the risk of a “Grexit.”
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European nationals are particularly upset that they have been forced to live under austerity conditions and have not been provided with a referendum as the Greek populace has. They are applying pressure on their politicians to extract large concessions from Greece in exchange for emergency funding. Ongoing conflicts in the Middle East also have the potential to cause market disruption. Potential policy errors by central banks and/or governments risk destabilizing a very fragile global recovery. This is especially true in the eurozone and China, where governments are trying to rebalance their economies. Under the heightened risk scenario, equity market returns could be 0% over the next few years.
Whichever one of these scenarios plays out, it’s clear that the outsized equity market returns we have experienced over the past few years are not likely to be enjoyed for the next few.