What has driven stockmarket returns and what will drive them in future?
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% a year1. The US, as is well known, has been the outlier and star performer, delivering closer to 11.5% 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) – dividends2
- 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 stockmarket, 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 rollercoaster 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.
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% 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% provides a solid base for returns but unless earnings recover, this is unlikely to be sustainable. UK companies paid out 80% 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.
Earnings growth – a positive driver
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↩
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