A BETTER ERA FOR GLOBAL EQUITIES / THE FINANCIAL TIMES COMMENT & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

A better era for global equities

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March 25, 2012 5:14 pm

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by Gavyn Davies



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Global equities have enjoyed a very strong start to 2012, rising by about 11 per cent year-to-date. This of course has been driven mostly by the improvements in the eurozone debt crisis and in the US labour market, which have raised hopes of stronger growth in global GDP in coming quarters. But on a longer-term view, equities remain in the doldrums. Relative to government bonds, equities in the developed economies have given negative excess returns for more than a whole decade, which is an extraordinary state of affairs in a free market economic system.

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As the first graph shows, the rolling 10 year excess returns in US equities relative to treasuries have been lower in recent years than at any time since the 1930s. But equities, the riskiest of all assets in the capital structure, cannot be outperformed indefinitely by government bonds, supposedly the safest of all assets. The scope for government bonds to perform strongly now looks limited. And current valuation of equities indicates that they should perform considerably better than bonds in coming years.



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There is plenty of evidence that the long term future performance of equities is best when the starting valuation for the asset class is particularly attractive, and vice versa. There are many ways to measure the “value” of equities, either relative to their own history or relative to alternative assets like government bonds. At the present time, these methods give mixed results.


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Relative to their own history, the valuation of US equities is roughly average, with a p/e ratio on the S&P 500 of about 13. This indicates that equity returns might be also be average from now on at about 7 per cent per annum. However, valuation in the eurozone and Asia is more attractive than in the US, suggesting that long term returns in these regions might be rather higher.



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Furthermore, the case for equities looks stronger if we compare equities not with their own history, but with government bonds. With 10 year bond yields around 2.2 per cent in the US, and the earnings yield on the S&P 500 standing at 7.7 per cent, there can be little debate that equities are very cheap by historic standards compared to bonds. Part of this could be unwound by a rise in bond yields back into normal territory. But even if bond yields were to rise to 5 per cent, which is a fairly extreme assumption, equities would still be offering an above-average risk premium relative to bonds.



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This implies that equities could provide significantly positive medium term real returns, even if bond yields were to rise markedly. According to Ian Scott at Nomura, the correlation between US bond and equity prices is usually negative when the treasury yield is below 5 per cent, which gives plenty of room for a “healthy” rise in bond yields as economies recover, without this doing any damage to equities.




So far, so good for equity optimists. But there is one major reason for possible concern about equities, which is shown in the second graph. The ratio of after tax corporate profits to nominal GDP in the US, otherwise known as the profit margin earned in the economy, is far higher at present than it has been at any time in post war history, and the same pattern is observed in many other developed economies. The profit margin was abnormally high even before the Great Recession in 2008/09, but in the aftermath of that recession, it has entered entirely new territory.
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The key question, then, is whether profit margins can be sustained at anywhere near these unprecedented levels. A recent research paper by James Montier at GMO argues that this is unlikely to be the case.

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He says that profit margins are more likely to revert to their long term mean in the next few years, and that this will result in sub-par growth in corporate earnings. This, in turn, will remove most of the upside for developed equity markets as earnings persistently disappoint analysts’ expectations.




The case in favour of mean reversion in profit margins is normally very strong. After all, there has been no long term uptrend in margins in most market economies in the past century or more. Whenever new technologies have created the chance for companies to reduce costs and to earn higher margins, this has proven to be short-lived, because new firms enter these markets, and competition quite quickly erodes excess profits. This is why the share of profits in the economy, and by implication also the share of wages, remains broadly constant over time.



Why should this time be any different? There are two possible reasons. The first is that the process of globalisation has greatly added to the effective supply of labour in the global economy, and this has resulted in downward pressure on real wages in the developed world. So far, the resulting declines in labour costs have been captured and retained by companies, rather than being regained by labour in the form of higher nominal wages, or via lower consumer prices. Since the effective global labour supply will rise considerably further in the coming decade (with India taking the lead as the growth in China’s labour force slows), the phenomenon of high margins may well persist.


.The second reason is that the output gap in the developed economies is larger than it has been in the past, and is also likely to persist for quite a while. A large output gap, along with a high unemployment rate, normally depresses real wages, and results in much higher profit margins. The same seems to be happening now.




In summary, equities in developed markets are cheap, if not relative to their own history, then certainly compared to bonds. Rising bond yields are not likely to do much damage to equities in the foreseeable future. The main risk comes from today’s elevated profit margins. But if margins can stay high as globalisation continues, then equity returns should enter a better era.