Credit Suisse Yearbook 2017: Low Interest Rates Hit Returns on Equities
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Credit Suisse Yearbook 2017: Low Interest Rates Hit Returns on Equities

The risk premiums on equities are unlikely to be as high in the future as they have been. This is the conclusion reached by the 2017 Yearbook published by Credit Suisse.

In order to make statements regarding future market developments, it is worth taking a look at the past. Therefore, in the latest Global Investment Returns Yearbook, professors from the London Business School present a far-reaching retrospective of the performance of equities, bonds, money market papers, real interest rates, and inflation. The analysis covers 23 countries and the years from 1900 to 2016. The Yearbook is published annually by the Credit Suisse Research Institute and is a reference work for investors worldwide.

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.

Uninterrupted Dominance of the US Equity Market

The dominance of the US equity market continues. Since the end of the Second World War, the US market has made up more than half of global market capitalization – with a brief interruption at the end of the 1980s, when the Japanese stock exchange was at the height of its bubble. As of the end of 2016, the capitalization of all listed US companies made up 53 percent of global stock market value.

Relative sizes of world stock markets, end-1899 versus end-2016

Relative sizes of world stock markets, end-1899 versus end-2016

Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists, Princeton University Press 2002, and FTSE Analytics FTSE All-World Index Series, December 2016.

Between 1900 and 2016, 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 percent. The risk-free money market, in contrast, generated 0.8 percent per year while bonds generated 1.8 percent. These are real revenues, meaning they have been adjusted for inflation.

Real return on equities, bonds and bills

Real return on equities, bonds and bills

Source: Elroy Dimson, Paul Marsh and Mike Staunton / Credit Suisse 

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 percent per year, while the money market came in below zero at -0.5 percent per year. Investors who invested in bonds, by contrast, achieved an annual return of 4.8 percent.

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 percent per year, bonds earned 6.6 percent, and money market papers still earned 2.8 percent.

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 have 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.

After analyzing the long-term dataset, the authors reached the following conclusions:

Mild Inflation Is Favorable 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 favorable backdrop for equities. This would speak in favor 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 percent in the years ahead.

Professor Paul Marsh, co-author of the Yearbook, and Michael O’Sullivan, CIO International Wealth Management, Credit Suisse, explain the key findings of the analysis: