Global Equities Expected Returns

Given all that I mentioned above, and the rather stark reading at the left hand side of the chart (probably the least believable for most people, if I had to guess), I thought it might be useful to share a couple more charts which provide a look at the concepts and inputs/breakdown for the equity expected returns, but also presents some historical context (e.g. how the past 5-years total returns compare to the forward looking return expectations).

First, in terms of the components, the equity expected return outputs are the sum of: dividend yield (+buyback yield adjustment) + expected earnings growth + valuation adjustment + USD hedging/FX adjustment (for global ex-US).

In other words: income + earnings growth + valuation change. Historically the income part tends to be reasonably steady, the earnings growth mostly positive (except for recessions), and valuation changes can be either a big contributor or sometimes large detractor to returns.

As the chart on the right below shows, the US stockmarket has turned in exceptional returns over the past 5 years, and this has resulted in historically stretched expensive valuations. Given the tendency for valuations to mean revert over the longer-run (cycles!) this means “valuation change” is likely to be negative over the coming years (the growth story is already in the price, and then some).

The main way these figures could be wrong would be if valuations stayed higher for longer, and/or if growth continued to surprise to the upside and out-punched any downside valuation change hurdle. But even then, we’d probably be talking modest returns vs negative returns, and certainly not a repeat of the past 5 years.

So it’s a prompt at the very least to think: “what if?“ —my discussions with institutional investors and wealth managers is that there is heavy pressure (peer-risk/career-risk) to walk the straight and narrow of US large cap stocks (and within that to stay very close to the index/passive). Again, even if you understand the intellectual argument, it’s a tough pill to swallow, and not what most expect.