Last year was a difficult one for equity investors, with many markets delivering negative returns. But experts are expecting an improvement in 2012, according to Towers Watson’s Survey of Economic Expectations, with forecast equity market returns of approximately 8% for the U.S. and Canada, 10% for emerging markets and 5% for international equity markets. That being said, there are some who expect much stronger returns, while others expect equity markets to continue to react negatively to ongoing uncertainty in Europe and global economic sluggishness. There are good arguments to be bullish and equally strong arguments to be bearish.
Charging ahead—the bull case
The chart below shows returns from investing in the U.S. equity market over the past century (we’ll use the U.S. market for illustrative purposes, given its long history). Investors have been rewarded handsomely, despite a number of global shocks, including two world wars. Those in the bull camp expect that the next 100 years will be no different.
Note: TMT refers to telecom, media and technology. GFC refers to the global financial crisis.
Equities have trounced bonds over the same time period (see chart below), despite the six nasty episodes shown in the chart above. The past 30 years have witnessed the largest bond bull market in history (Canadian yields dropped from near 20% in 1982 to the current 2% yield on a 10-year bond). People who are bullish believe bonds are priced to perfection, and investors can’t be satisfied with a less than 3% return for 30 years. In fact, they would argue that government bonds are no longer the “risk-free” asset.
Another consideration is equity valuations (as measured by price/earnings ratio). By historical standards, valuations are about average, at 15.7 times earnings.
However, 15.7 times earnings understates the expected ratio as the current market is more diverse than it was in the early 1900s when investors had a handful of banks and railroad companies to buy. Now investors can choose from thousands of stocks and dozens of industries. Over the past 30 years, the P/E ratio has averaged 19, which would make current valuations not expensive at all.
Still hibernating—the bear case
While it is appealing to believe that the bull case will prevail, there are also many things to worry about according to those who are bearish. There are imbalances everywhere: there remains a glut of U.S. housing, with more and more people defaulting on loans and walking away from their properties.
While we frequently hear about the U.S. deficit, other countries are experiencing similarly large deficits (see the U.K. in the chart above). We could equally reference many other European countries—Greece, Portugal, Italy, France—and even Canada. Recent guidance suggests that Canada will continue to experience deficits into 2016. And let’s not forget that we typically focus only on the federal debt. When provincial debt is included, total Canadian government debt is approaching 100% of GDP (well into European territory).
In considering the bull’s picture of stock returns over the past 100 years, it is important to remember that the U.S. was experiencing a massive tailwind, as it effectively went from emerging market to the world’s only superpower. The U.S. economy now faces massive headwinds, both demographic and financial, as do many other developed market economies. In addition to U.S. housing issues, government and consumer debt has continued to grow and, along with it, debt financing costs, which will constrain GDP. Rapidly spiralling dependency ratios and healthcare costs serve as a millstone around the developed economies’ necks.
Some are even concerned that U.S. markets could follow the same path as Japan. In the chart below, we show actual bond and equity market returns for the U.S. between 1999 and 2011—which look eerily similar to Japanese bond and equity market returns between 1989 and 1999. The dotted lines show what would happen if U.S. markets follow the same trajectory as Japanese markets.
As you can see, both arguments—bull and bear—are compelling, but neither is conclusive.
Towers Watson’s own view is that we find global equities moderately attractive over the next three years. Thinking about portfolio risk, we remain neutral and do not see any compelling reason to overweight or underweight risky assets such as equities at the present time.