UK equity investors who focus on developed markets shouldn’t expect to make more than 5.3% a year over the medium term, according to Robeco’s annual Expected Returns report.
The lower-than-average figure – the FTSE 100 and S&P 500 have delivered about 6.5% and 11.8% per annum respectively over the long term – has been attributed to an increase in the risk-free rate as interest rates have risen, as well as other factors.
However, the report said that investors in emerging market equities could expect to make 6.5% a year.
Source: Robeco
Robeco’s annual Expected Returns report forecasts the five-year performance of major asset classes using assumptions based on valuations, macroeconomics and the effect of climate change.
In the latest report, it said that uncertainty over the direction of economic policy has made predictions more challenging and its conviction in its forecasts is lower compared with previous years.
In 2021’s publication, Robeco predicted valuation multiples on equity markets would decline by more than a third over the medium term. Yet while the S&P 500’s price-to-earnings (P/E) ratio is down by 32% since then, it claimed the de-rating process is not over.
“The majority of the observed multiple compression last year is predominantly of a cyclical nature, due to the transition of the equity market from the expansion phase – in which multiples contract but earnings growth still contributes positively to total equity return – to the early slowdown phase in the equity cycle, in which both earnings growth as well as P/E ratios start to decelerate,” the report said.
It added that there are three emerging secular trends that should continue to push multiples down, irrespective of where we are in the cycle.
First is that interest rates will continue moving up and are likely to settle above 3% in 2023. The higher risk-free rate compared with last year warranted lower P/E ratios.
“The historical distribution of equity valuations also shows S&P 500 valuation levels are typically lower in higher inflation regimes,” the report noted.
“We imagine that the cyclically adjusted P/E ratio for the S&P 500 will now settle around 21x from its current level of 29x by the end of 2027. This is close to the 40-year average Shiller CAPE [cyclically adjusted price-to-earnings ratio].”
Second, the report said that cashflows are likely to become more volatile, meaning investors will pay less for them.
“Consumption volatility within a five-year window has surged in developed economies from below 1% to 6% since the start of the pandemic and has not shown signs of easing,” it continued.
“Instead, we enter a high consumption-volatility regime in our base case as we observe a shift in consumption preferences (from services to goods) and a higher frequency of shocks that impact consumption growth. The resulting uncertainty about future cashflows requires investors to demand higher ex-ante risk premia for allocating to equities.”
Third, it pointed out that financial conditions were vital when predicting the direction of equity multiples and warned that the impact of quantitative tightening on liquidity could be twice as powerful as that of quantitative easing.
Robeco’s base case is that the Federal Reserve will have reduced its balance sheet by 20% by the end of 2024, equivalent to $95bn a month.
“This source of additional tightening of financial conditions equates to 50 to 75bps of conventional policy rate tightening, according to the Federal Reserve Bank of New York,” it added.
The good news is that equity market multiples already reflect the intended balance sheet shrinkage back to pre-Covid levels.
However, Robeco warned the market hasn’t discounted the asymmetry that will become apparent between quantitative easing and quantitative tightening.
“Quantitative tightening will happen at a higher pace compared with the 2017 to 2019 episode, aggravating the negative liquidity impact through shrinking bank reserves,” it added.
“In contrast to between 2017 and 2019, the Fed is now joined in its balance sheet contraction by other central banks, with the joint balance sheet contraction lowering global excess liquidity at a faster clip.”
Moving away from the developed world, the report said share price multiples in emerging markets peaked in 2021, and now stand at 17.2x, below the long-term average. Yet while it said the derating process looks more mature in this sector, it warned secular headwinds would increase and the discount between emerging and developed markets was there for a good reason.
“The expected deceleration in GDP growth differentials in emerging markets versus developed markets – with the underlying key assumption that China won’t see greater than 4.5% real GDP growth annualised between 2023 to 2027 – will inhibit, in our base case, multiple expansion of emerging markets versus developed markets, and will even see a marginally larger discount by 2027.”
Yet the report said the widening discount did not amount to a bearish view on emerging markets.
“Instead, our view of a weakening US dollar, peaking developed market yields and stronger fiscal support for Chinese households in the next five years, bodes well for emerging market equity outperformance, especially for US dollar investors,” it added.
“Within the emerging market universe, countries with a relatively low sensitivity to Chinese-specific growth risk could outperform the benchmark.”