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Markets await a ‘reversion to mediocrity’


It’s hard to think about tomorrow when you’re having a good time today, and a decade of ripping equity market returns has investors convinced that the party can go on.

While equity markets have outpaced “even the most optimistic forecasts” in recent years, Northern Trust Asset Management (NT) believes that those red hot returns could soon cool.

“Forecasting muted equity market returns has been a losing proposition in recent years. Many over the past decade (candidly, including us) have believed that elevated valuations and a muted growth outlook would, at the very least, constrain future returns,” NT wrote in its Capital Market Assumptions report, which was announced with input from Jim McDonald, chief investment strategist (pictured).

“The fact that recent robust returns were more due to margin and valuation expansion – as opposed to sales growth – suggests that our call for a “reversion to mediocrity” in global economic growth may (finally) mean mediocre global equity returns ahead.”

The key driver here is the aforementioned “reversion to mediocrity”, with NT forecasting sluggish global economic growth of around 2.9 per cent in the aftermath of the extraordinary stimulus measures unleashed in the depths of the pandemic. That’s mostly due to the demographic challenge posed by an aging workforce – NT believes it will be easy to manage the impact on supply but not the impact on debt growth – and withering debt growth. And while elsewhere NT warns that the dynamics of global growth do not necessarily impact the share market, it does believe that the mediocrity will trickle through.

How mediocre will markets be? NT is broadly forecasting mid-single-digit annualized returns worldwide, with a five year forecast of 4.3 per cent for the United States and 6.2 per cent in the United Kingdom (the highest in the developed market set) as it shakes off the post-Brexit blues. While Europe will also benefit from “increased stability as well as a longer tailed post-pandemic recovery”, it will manage only 4.7 per cent. The emerging market set is expected to be similarly subdued, at 5.3 per cent.

The forecast flows from how NT believes its thematic view will impact four equity market “building blocks”: revenue growth, which is based on nominal economic growth forecasts weighted by each equity index’s geographical exposures; profit translation, representing a company’s ability to turn revenues into per-share earnings; valuation impact, based on expected changes in price-to-earnings ratios; and dividend yield estimates, based on current levels.

“The US has seen most of its debt-fueled boost and will return more quickly to its longer term channel. Europe will eventually revert to a lower growth channel than the U.S. but will take longer to get there as it will enjoy a couple of years of above-trend growth thanks to a delayed recovery and deployment of fiscal stimulus,” NT said. “Finally, China’s secular growth story is nearing its final chapters as low-hanging economic fruit (urban migration) gives way to challenging demographics.”

However, NT notes that its previous forecasts have perhaps been “too pessimistic” despite correctly predicting the current low interest rate paradigm. In its 2016 report, NT predicted that global equity markets would return 5.4 per cent – a long way off the actual 15.3 per cent figure – with the resulting strategic asset allocation (SAA) undershoot representing its “biggest forecast miss in the time (NT) have undergone this exercise”.

“In fact, never before has our SAA forecast been more than 0.5 per cent off the actual result. This speaks truly to the impressive gains equity markets have provide over the past five years, even in the face of elevated valuations and global macro uncertainties,” NT wrote.

“If there is one key lesson to be learned here, it is to understand the path of least resistance for risk assets is higher – and the longer the investment horizon, the better the odds of realizing a return premium by taking on (appropriate levels of) risk.”

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