Basing investment decisions on the extrapolation of capital markets returns from recent, relatively short periods is a common mistake. Viable conclusions about long-term expected returns cannot be drawn from return data for periods shorter than several decades, and even then, investors should be mindful that long-term statistics are beginning- and end-point sensitive and that returns are more variable than commonly assumed. Still, consideration of shorter time periods within a longer-term context can provide a powerful framework for evaluating current market conditions.
Eurozone equities (22.7%) advanced in 2021 on strong earnings growth, and inflation rates surged to multi-decade highs. Eurozone equity performance ranked in the 70th percentile of calendar year returns since 1951, as equities continued to rebound from 2020’s pandemic-driven drawdown. Eurozone stocks have now returned 15.8% annualized over the trailing three calendar years, which was the strongest three-year performance since the period ended in 2007. Global price inflation was a prominent market theme in 2021, and the Eurozone was no exception. Consumer price inflation accelerated to 5.0% year-over-year by December, the highest rate since 1991. The inflationary spike resulted from a strong demand recovery in the aftermath of the COVID-19–induced recession and its related supply constraints. Resurgent consumer prices have bucked their longer-term downtrend since the high inflation environment of the late 1970s/early 1980s. In fact, December’s inflation print was more than four times higher than its trailing ten-year average, the most extreme reversal from longer-term trends on record.
Recent Eurozone equity returns have struggled to keep up with their long-term average. Investors in Eurozone stocks have earned a nominal average annual compound return (AACR) of 10.4% over the past ten years, slightly below the full-period (1951–2021) AACR of 10.5%. Relatively weak performance has persisted for some time. The rolling ten-year AACR for Eurozone equities has been below the full-period average for the past 15 years. However, investors should bear in mind that rolling AACR analyses are sensitive to beginning- and end-point timing, even over ten-year periods. The latest trailing ten-year return—which is the strongest since the period ended December 2006—now excludes performance from the height of the European Sovereign Debt Crisis in 2011 when Eurozone stocks returned -15.2%. In another example, ten-year AACRs reached 9.9% through February 2019, which was their strongest trailing ten-year return since the period ended May 2007. That ten-year window excludes the worst months from the global financial crisis (GFC) and begins when Eurozone equities hit their nadir in March 2009.
Eurozone equities, bonds, and cash all outpaced inflation over very long-term periods, based on data since the mid-20th century. Over rolling 50-year periods, real AACRs for Eurozone stocks ranged from a low of 3.7% to a high of 8.7%, outpacing inflation by the widest margin. Eurozone bonds and cash also gained in real terms, even during the weakest performance periods, with returns ranging from 1.8% to 3.5% and from 0.3% to 0.8%, respectively. Eurozone inflation has averaged 3.7% annually since 1950, roughly in line with other developed economies. For comparison, benchmark Eurozone government bonds and cash produced full-period AACRs of 5.7% and 3.7%, respectively, over the same time span, which is a significantly narrower spread vis-à-vis inflation relative to stocks versus inflation. Still, given today’s unprecedented low yields, Eurozone bonds and cash may have a more difficult time outpacing inflation in the years ahead. With negative central bank policy rates, even low inflation can eat away at purchasing power.
Over the long term, Eurozone equity investors have a high probability of being compensated for the additional risk of holding stocks. Since 1950, Eurozone equity returns exceeded bond returns during 68% of all five-year periods, 76% of all ten-year periods, and 95% of all 25-year periods (calculated on a nominal basis using rolling monthly data). While equities tend to outperform in the long term, there have been periods of underperformance over rolling five-year periods, as volatile equities are prone to larger drawdowns than bonds. Such periods are a reminder of the ballast fixed income allocations can provide to portfolios in terms of diversification, though today’s historically low-yield environment has challenged this conventional wisdom.
Earnings growth and dividend reinvestment are the primary contributors to equity total return over time, while the effects of valuation mean reversion diminish the impact of multiple rerating. Earnings growth provided the highest degree of return contribution since 1969, on average, but can vary significantly from decade to decade. Dividends provide a steady stream of reliable income, but their contribution is weaker in magnitude, comprising only about half the contribution provided by earnings. Earnings growth has been the primary driver of performance so far this decade (2020–21), as the strong earnings rebound in 2021 more than offset the pandemic-driven earnings contraction in 2020.
Starting valuations are a useful indicator for long-term (10+ years) subsequent equity returns, but the relationship is somewhat weaker over shorter time horizons. Normalized valuations and subsequent returns have a stronger relationship over long time periods (e.g., ten-year subsequent returns), but starting valuations alone do not completely explain subsequent returns—many factors can influence equity performance. Since 1979, our cyclically adjusted price-to–cash earnings (CAPCE) ratio for Europe ex UK stocks has explained 74% of the variation in subsequent ten-year real returns, a strong yet imperfect guide to future performance. At December 31, 2021, Europe ex UK equity valuations ended in the 91st percentile of historical observations, and from this valuation decile, the median subsequent ten-year real return for equities has been -2.3% per annum.
High- or low-valuation environments alone are not a catalyst for market reversals and may persist for several years; waiting for valuations to mean revert can be an exercise in frustration. Low valuations provide what famed investment analyst Benjamin Graham called “a margin of safety.” High valuations, on the other hand, typically price in lofty projections for the future, providing little room for error. Despite uncertainty regarding the timing of market reversals, the historical record for Eurozone equities is clear—periods of low valuations are followed by higher long-term subsequent returns, while periods of high valuations are followed by poorer long-term returns.
Europe ex UK equity dividend yields are not statistically related to subsequent performance; normalized earnings multiples are the more useful indicator. Europe ex UK dividend yields explained only 18% of the variation in subsequent ten-year real AACRs over the past 50 years, which pales in comparison to the explanatory power of normalized earnings multiples. For example, from the 2021 year-end dividend yield of 2.1%, the historical range of subsequent Europe ex UK equity real ten-year returns was about 15 percentage points. Despite the weak statistical relationship, dividend yields and subsequent returns display the expected positive relationship, in that higher starting dividend yields (i.e., lower equity prices relative to dividends) have typically been associated with higher subsequent ten-year returns relative to long-term averages. However, the importance of dividend reinvestment as a driver of total return should not be understated. In fact, since 1969, Europe ex UK companies managed to maintain a net positive average dividend growth rate during recessions. While earnings growth is more sensitive to the economic cycle, dividends provide a relatively stable tailwind to total returns.
Subsequent nominal ten-year Eurozone bond returns closely track the starting yield. Eurozone bond yields remained near their all-time lows at year-end 2021, creating a challenging environment for future long-term returns. There is no comparable period of such low yield levels in the Eurozone, but if the strong correlation between starting yields and subsequent performance observed since 1970 (correlation coefficient=0.81) is a guide, Eurozone bonds are likely to post flat returns in the ensuing ten years. Additionally, from these levels even low-price inflation would result in losses in real terms. While investors benefited from falling yields over the past 40 years, with Eurozone bonds returning 7.0% annualized since 1981, they may need to consider other avenues for defensive portfolio diversification in today’s environment. During the COVID-19–driven equity market sell-off, European bonds with negative yields provided poor returns, highlighting their reduced capacity as a defensive hedge.
There is a distinct inverse relationship between the level of government bond yields and equity market valuations in European markets. Many have argued in recent years that high stock valuations, particularly in the United States, are justified (or at least in part explained) by the low level of government bond yields. The reasoning is straightforward; when discount rates fall, the present value of future cash flows increases, thus pushing up valuations. However, government bond yields do not tell the whole story. Since 1979, ten-year European government bond yields have explained 43% of the variation in equity market valuations, but they do not account for the other half. While an inverse relationship exists overall, there can be periods when equity valuations and yields move together. For example, in the early 2000s period preceding the GFC, there was a positive relationship, in that equity valuations and yields both increased. Given the possibility of differences across market environments, investors must consider the drivers of changes in interest rates, rather than their outright levels, and what impact such drivers may have on equity markets.
The relationship between asset prices and inflation is complex and nuanced. Due, in part, to the extraordinary amount of fiscal and monetary stimulus extended in response to the COVID-19 crisis and global supply chain disruptions, inflation has risen to multi-decade highs. Inflation’s impact on Eurozone equity returns is unclear; median stock performance is the lowest during seventh-decile inflationary periods, but equities experienced the largest downside during fourth-decile inflationary environments. The highest inflationary periods can erode nominal returns, but upside and median performance across the other inflationary deciles are largely similar. In nominal terms, bonds exhibit limited downside during periods of high inflation, as higher yield levels historically help offset any capital losses as bond prices fall. However, bond markets do suffer in real terms when consumer price levels increase 3% annualized or more.