The risk premiums on equities are unlikely to be as high in the future as they have been. ”
Uninterrupted dominance of the US equity market
Between 1900 and 2000, equities were by far the highest-performing asset class compared to bonds or money market papers. On a global basis, shareholders achieved an annual return of 5.1%. The risk-free money market, in contrast, generated 0.8% per year while bonds generated 1.8%. These are real revenues, meaning they have been adjusted for inflation.
A very different picture is shown by the period from 2000 to 2016, which saw three equity market crashes and a dramatic fall in interest rates: Equities returned 1.9% per year, while the money market came in below zero at -0.5% per year. Investors who invested in bonds, by contrast, achieved an annual return of 4.8%.
Investors experienced the best of all worlds in the 20 years preceding the millennium change. From 1980 to 1999, the return level for all asset classes was higher than before and afterwards. Equities earned 10.6% per year, bonds earned 6.6%, and money market papers still earned 2.8%.
Time for equities?
Until one year ago, there was a search for investment ideas that were most likely to be successful in a deflationary environment. In the meantime, the political environment has changed and, therefore, so has the investment themes. Deflation fears have been replaced by the expectation of a return of slightly rising prices. The question is no longer whether and to what extent government bond returns can fall. Rather, the question is whether we have arrived at the end of the 30 year Bull Run in the bond market and thus whether the below average performance of equities compared to bonds is over.
Mild inflation is favourable for equities
Equity investors don’t need to worry about a slight rise in inflation. First, corporate earnings and dividends are rising in tandem with prices in general. Second, history shows that the transition from a slightly deflationary environment – as has prevailed over most of the past decade – to one of mild inflation constitutes a favourable backdrop for equities. This would speak in favour of the long overdue reallocation of assets from bonds to equities.
Decrease of risk premium
However, equity risk premiums are likely to be lower in the future. The risk premium is the additional return that shareholders receive for accepting a greater degree of risk than investors in the money market. Since real interest rates remain at low levels, this is likely to depress returns on all asset classes – including equities. Given that equity investors made a 4.2 percentage point higher return than money market investors in the 1900–2016 period, the authors predict an additional return of just 3 to 3.5% in the years ahead.
The conclusion reached by the 2017 Yearbook is that the risk premiums on equities are unlikely to be as high in the future as they have been. From the vast amounts of data, interesting observations can be made and some conclusions can be drawn as to the further development of the various asset classes.
Download the 2017 Global Investment Returns Yearbook