What has driven returns in different stock markets?
When we look back over the past three years, investors have earned remarkably similar returns in local currency terms in very different parts of the world.
UK, eurozone, Japanese and emerging market equities have all returned close to 9.5 per cent a year [1]. The US, as is well known, has been the outlier and star performer, delivering closer to 11.5 per cent a year.
However, when we look behind the numbers at what has been driving that performance, we find an altogether different and more diverse set of circumstances. The chart below decomposes returns over the 2015-2017 period into their key components:
- Income (blue bar) – dividends [2]
- Earnings (green bar) – how fast have companies grown their earnings?
- Valuations (red bar) – how has price/earnings multiple changed? Does the market now value companies more or less, for a given level of earnings
The sum of these components approximates the return on the stock market, which is shown with a black diamond.
Past performance is not a guide to future performance and may not be repeated.
Three key features stand out:
- US returns have been driven predominantly by increasing valuations. Earnings growth has been next to nothing.
- Japanese and eurozone equities have been powered by a combination of strong earnings growth and dividends. The market has failed to reflect these better fundamentals in valuations, which have stagnated.
- UK equities have had a roller-coaster ride. The decline in commodity prices contributed to a collapse in earnings over the past three years, given the market has a large allocation to this sector. However, investors have been prepared to value companies higher relative to those depressed earnings, which has softened the blow. One explanation for this is that investors have priced in a sustained recovery in commodity prices.
When we look at 2017 in isolation we find a different set of drivers. Synchronised and strong earnings growth everywhere has been the main engine of returns in all markets.
So, as investors, what should we make of this? Firstly, the fact that US returns have been so poorly underpinned by fundamentals is a concern. Stellar returns have been built on shaky foundations. This can only go so far but reassuringly, 2017 saw strong earnings growth in the US and 2018 is also shaping up for more of the same. The necessary rebalancing in the drivers of returns is underway, which suggests the rally may yet have legs.
Finding unloved markets
Elsewhere, it pays to have an eye on those markets that have been somewhat unloved. Despite generating the strongest earnings growth of all markets shown, the valuations of Japanese equities have languished relative to the rest of the world. They are lower at the end of 2017 than a decade earlier. After decades of poor growth, investors have remained somewhat untrusting of the recovery. Should this hold out, then there is more potential here than just about anywhere else for increasing valuations to boost returns.
European equities have also not been hugely rewarded for the earnings recovery that has commenced. Valuations have hardly changed since 2013. Given their earlier stage of the economic cycle, earnings growth is likely to drive returns in 2018 with potential support from valuations.
The UK equity market has been the worst place to be invested from an earnings standpoint. Earnings rebounded sharply in 2017 but remain over 40 per cent lower than their 2007 peak and even 30% lower than after their mini recovery which fizzled out in 2011.
A chunky dividend yield of close to 4 per cent provides a solid base for returns but unless earnings recover, this is unlikely to be sustainable. UK companies paid out 80 per cent of their earnings in 2017 to cover dividends, way above the long-term average of around 50%. Commodity prices have rebounded and both dividends and earnings have a lot riding on that holding out.
The drivers of emerging market equity returns have been reasonably well balanced over the past three years. Valuations have risen but are not as extended as in some other markets and earnings stand to benefit from the synchronised global recovery and weakness in the US dollar. The potential for positive contributions from all factors remains on the cards in 2018.
At a very high level, the supportive economic backdrop suggests that earnings growth should positively contribute to all markets in 2018.
Dividends are also well supported in all markets other than the UK, which is beholden to commodity prices.
The big differences could arise from valuations. No market is immune to falling valuations but that does not mean returns have to be negative, if the other two drivers contribute enough. A year of solid, if not spectacular, returns could be on the cards.
1. Emerging market equities represent a basket of different currencies. Local currency for emerging markets has been taken to be USD.↩
2. Technically, the income return has been calculated as the difference between the change in the share price and the total return earned on an investment↩
Important Information: The views and opinions contained herein are those of Duncan Lamont, Head of Research and Analytics, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal.Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.
Morning Wire's opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by Morning Wire