10 reasons why you should expect lower returns from equities over the next 10 years: Alphen

Shaun le Roux of Alphen Asset Management writes that many equity managers tend to have something hardcoded into their DNA that results in them always being positive on the markets.

Right now, the bulls are focused on what will clearly be an impressive pick up in earnings growth in 2010. Many currently favour the cyclical shares that would benefit from a strong economic recovery.

Alphen is sending a strong message that we feel some caution is warranted after the strong rally on equity markets in 2009. We are not outright bearish, but are becoming increasingly focused on risk in our analysis of stocks and markets.

In particular, we emphasise that we cannot see any scenario other than one in which equities deliver fairly moderate and uninspiring returns over the next ten years, particularly when compared to the decade just past. The JSE All Share delivered real (after inflation) total returns between 2000 and 2009 of above 9% per annum. This was a phenomenal performance. Interestingly, the JSE started the decade on roughly the same rating as it ended the period, a price-earnings (PE) ratio of just above 17. So, the returns derived have resulted entirely from ten years of healthy profit growth. Profit growth, in turn, was boosted initially by significant weakening in the rand, and thereafter by the massive earnings growth cycle of 2004 to 2007 that boosted all sectors of the stock market.

It is worth pointing out that while the JSE enjoyed such positive returns over the past decade, most developed markets printed negative ten year real returns. They had the misfortune of starting 2000 on very lofty ratings.

The bad news is that we feel it is very unlikely that equities will repeat their real returns of the past decade over the next ten years. There are ten reasons why we foresee much lower equity returns for the next ten years.

1. Rating

The market ended 2009 on a PE ratio of over 17 times earnings. A simple regression of what the subsequent returns have been when the market has traded at such levels in the past clearly demonstrates that, based on past experience, unless we have a significant multi-year earnings growth cycle, the returns can be expected to be moderate at best.

2. Profits

Alphen does not see a booming profit cycle unfolding. We see a healthy bounce-back in profits from the low base of 2009, but favour a structurally lower global growth environment. Over the longer term, corporate profits will always follow nominal GDP growth, and we don’t expect a repeat of the growth rates of the previous decade.

3. De-leveraging

By 2007 the West had allowed one of the largest credit bubbles in history to develop. The process of de-leveraging excessive debt levels, by both banks and consumers, and raising savings rates is certainly not over and is going to play out over the decade ahead. The result will be much lower availability of credit than during the boom and hence lower growth rates.

4. Uncertainty

Economies around the world are emerging from the worst recession in 60 years. Grave concerns remain surrounding the levels of unemployment, the health of Western consumers and ballooning fiscal deficits. At some point, government stimulus will abate and start to be withdrawn and it remains to be seen whether economies will be strong enough to stand up without crutches. After the recovery of 2009, the future path looks a lot more uncertain and investment markets hate uncertainty. In times of uncertainty, investors demand a higher risk premium on their investments. A higher equity risk premium equates to a lower PE ratio for stocks.

5. Higher cost of money

Investors are almost certain to at some stage demand a higher yield on the money they have lent to highly-indebted governments in the form of treasuries and gilts. It is highly likely that bond yields will rise materially at some point in the years ahead given the massive expansion in G7 issuance and the eventual termination of quantitative easing. Higher bond yields mean a higher discount rate for equities.

6. The end of secular disinflation

The US Fed broke the back of inflation in the early 1980s and a very strong bull market in asset prices followed. The SA Reserve Bank had similar success in the early 1990s and domestic asset markets have also benefited tremendously. The global secular disinflationary cycle is likely at an end, given the explosion in global money supply.

7. Regulatory intervention

It is now recognized that regulation of the global banking sector was too lax in 2007. Inevitably, that situation will flip over to over-regulation and current proposed measures to clamp down on profitability within the investment banks will find favour with the public, especially in the US. In tougher economic conditions governments are far more likely to intervene in market pricing in an attempt to curry favour with their constituents, usually to the detriment of corporate profitability.

8. Higher taxes

Governments around the world have seen their debt levels explode. They will find it increasingly difficult to service such debt levels if borrowing costs do not stay low and economic growth rates remain subdued. It is highly probable that tax rates will need to rise to fund fiscal revenue shortfalls. Higher corporate tax rates will dampen profits.

9. Building inflationary expectations

It is far easier to achieve healthy real returns when inflation is low. The huge expansion in the monetary base could have a dire impact on inflation further down the line, especially because the fragile nature of the economic recovery will make it difficult for central banks to withdraw money supply without endangering the recovery. Up until now, global financial markets have been pretty relaxed about the outlook for inflation. Recently, it has become noticeable that global inflation expectations are starting to tick up.

On the domestic front, the future rises in Eskom price tariffs will have a material impact on both producer and consumer price inflation. Also, Alphen views the rand as being over-valued. It is susceptible to an adjustment in global risk appetite and rand weakness is bad news for domestic inflation.

10. Emerging market valuations

The consensus view is that Emerging Markets (EM) have and will continue to grow faster than Developed Markets. We do not disagree. The result has been strong demand for EM equities and they have out-performed the developed world markets by some margin. However, EM valuation levels are starting to look quite rich and Alphen would generally prefer to invest in relatively cheap first world stocks with a presence in strong growth markets.

In 2009, South Africa was a recipient of the EM portfolio flows. What bears watching is the fact that many of our EM peers have structurally better trade and savings ratios which will make them more defensive should the economic recovery falter. Domestic equities will be vulnerable to a shift in global investor sentiment.

Although Alphen encourages investors to factor lower equity returns into their expectations, we continue to favour equities as the asset class best suited to producing the inflation-beating real returns over the long run that are necessary to grow one’s investment capital. In the environment as we see it, careful equity selection will be required. We strive to own relatively cheap, lower risk, quality companies and have a strong preference for high dividend payers. We are especially careful of stocks that could well disappoint the market on account of the growth expectations that are currently being priced-in.