[Mb-civic] Realistic rewards Economist

Mon Aug 23 12:30:05 PDT 2004

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Aug 19th 2004 
>From The Economist print edition

The return on equities over the next decade is likely to be much lower than
most investors expect

AFTER rebounding strongly in 2003, America's S&P 500, the benchmark index
for American stockmarkets, has fallen by 8% since its high earlier this
year. America's battle-hardened investors seem to think of this as little
more than a flesh wound. Surveys suggest that they still expect average
annual returns from equities of at least 10% over the next decade; many,
indeed, have based their retirement plans on this assumption. Alas, they are
likely to be severely disappointed.

 That might seem strange. After all, these expectations are far lower than
at the peak of the bubble in 2000, after five wild years had delivered
annual average returns of 25% and investors expected more of the same. They
also look fairly conservative compared with the annual return of 13% that
stocks delivered during the 45 years to 1995, before the bubble inflated.
However, a study by Martin Barnes, an economist at the Bank Credit Analyst,
a Canadian research firm, concludes that, at best, the average return over
the next ten years is likely to be half that over the past half century.

His sobering forecast is based on two assumptions, both very reasonable. The
first is that, because of lower inflation, company profits are unlikely to
rise by more than 5% a year over the next decade, a bit slower than the
average of 7% a year over the past 50 years. In the long run, profits tend
to grow in line with GDP, and America's nominal GDP is thought likely to
grow by around 5% a year over the next decade (3% real growth plus 2%
inflation). Although profits have outpaced GDP over the past couple of
years, this is unlikely to continue because pre-tax profit margins are
nearly at their highest in 35 years. And since firms now operate in a world
of greater competition, profit margins are, if anything, more likely to fall
than to rise.

 Mr Barnes's second assumption is that there is little scope for a sustained
rise in the valuation of shares. The S&P 500 is currently trading at around
18 times historic operating profits. That is far below its ratio of almost
30 at the peak of the bubble, but still higher than its 50-year average of
15. Mr Barnes's ³optimistic² scenario assumes that the p/e ratio stays flat
over the next decade as a whole and the S&P 500 rises in line with profit
growth of 5% a year. Adding in dividends, this would give an average annual
return of 6.7%. That implies an average real return of only 4.7%, compared
with almost 10% in the half century to 2000. However, history suggests that
there is a risk that the p/e ratio could fall over the next decade. In an
alternative scenario, Mr Barnes assumes that the p/e ratio reverts to its
historic average of 15. If so, the annual return would be a measly 4.7%.

 Investors have become used to much higher returns than the range of
4.7-6.7% suggested as likely by Mr Barnes because their expectations are
still coloured by the 18% average annual return of the bull market from 1982
to 2000. But those two decades of falling inflation and falling interest
rates provided an exceptional, probably unique, boost to equities. The
present era of low and stable inflation is good for economic growth. It is
unlikely to be good, however, for financial markets or, indeed, those that
rely on them for their living.

Belt tightening

Lower equity returns have serious implications for financial-services firms
and consumers. The bloated financial sector will need to go on a diet. Two
decades of above-average returns from shares and bonds (thanks also to
falling inflation), and hence a big increase in the public's appetite for
investing in shares, caused a huge expansion in the financial-services
industry. Employment in the financial sector and its share of GDP more than
doubled between the early 1980s and 2000 and have fallen only slightly
since. More extraordinary still has been the surge in the financial sector's
share of total stockmarket capitalisation, from 6% in 1980 to 23% this year.

 Lower financial returns will mean slower growth in commissions and
investment-management fees. Over the past two decades, as markets have been
liberalised, financial firms have relied less on commissions and more on
trading revenues. But these will be harder to come by in a world of low
returns. That is why many banks are now gearing up their returns with more
borrowed money. But when this latest strategy comes unstuck because of the
greater volatility which the strategy itself will eventually cause in
financial markets, banks and fund managers will be under pressure to shrink.

 Far more worrying, of course, is what lower returns mean for consumers.
Underfunded pension schemes hoping for another bull market in shares to fill
the gap are likely to be severely disappointed. And because companies'
profits will be squeezed as employers are thus forced to make bigger
contributions to pension funds, the death knell for defined-benefit pension
schemes cannot be that far off.

Partly for the same reason, those that rely on their own investments are
unlikely to fare better. Anybody who has based retirement plans on the
assumption that equities will do as well in the future as they have done in
the past is in trouble. Big gains in share prices boosted household wealth
and caused a large drop in saving over the past two decades. Why save much
if booming shares did the job for you? Since this particular get-rich-quick
scheme lost some of its allure after 2000, households have shifted their
affections to property, the price of which has taken over where stockmarkets
left off. Surveys suggest that home-buyers also expect double-digit returns
over the next decade. Alas, this is very unlikely: house prices in many
cities are already at record highs compared with incomes and rents.

 If actual returns on assets turn out much lower than expected, households
will be forced to save more and spend less to meet their retirement goals.
Mr Barnes hopes that household saving will rise gradually over several
years. This would present only a gradual headwind to economic growth. The
risk, of course, is that saving rises much more quickly.