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. 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 (-12.3%) and bonds (-21.8%) declined sharply in 2022, buffeted by surging inflation and energy prices, tightening central bank policy, and slowing economic growth. Eurozone stocks posted their first annual decline since 2018 (-12.7%), with the drawdown slightly less severe than the average experience when calendar year performance turns negative (-16.0%.) Still, the Eurozone equity correction in 2022 followed a strong performance run in the three years prior when shares returned more than 50% cumulative, which was the strongest three-year return since the period ended in 2007. The Eurozone bond drawdown was the worst on record, as low starting yields failed to offset capital losses from the 290-basis point (bp) surge in ten-year government bond yields (also the largest on record.) Indeed, ten-year euro area bond yields started the year at just 0.25%, with the European Central Bank’s benchmark deposit rate at -0.50%. Performance in 2022 was an important reminder of the outsized impact external shocks (in this case, primarily Russia’s invasion of Ukraine) can have on capital markets performance.
Eurozone consumer price inflation was a prominent market theme in 2022. Inflation accelerated to a peak of 10.6% year-over-year in October, the highest rate since 1981. The inflationary spike resulted from a confluence of factors, including the strong post-COVID demand recovery, supply-chain constraints, and Russia’s invasion of Ukraine that catalyzed higher commodity prices. Resurgent consumer prices bucked their long-term downtrend since the high inflation environment of the 1970s and 1980s. In fact, October’s inflation reading was more than 6x its trailing ten-year average, an unprecedented reversal according to our data since the early 1950s. This rapid inflation spike was a key factor behind the increased correlation of equity and bond returns. And although inflation climbed to extreme levels based on recent memory, higher levels have been reached historically.
Recent Eurozone equity returns have struggled to keep up with their long-term average. For the full history analyzed (1951–2022), investors in Eurozone stocks have earned a 10.1% nominal average annual compound return (AACR). Over the past ten years, however, Eurozone equities posted a nominal AACR of 7.1%. Relatively weak performance has persisted for some time, as the rolling ten-year AACR for Eurozone equities has been below the full-period average for much of the past 15 years. However, rolling AACR analyses are sensitive to the timing of beginning and end points, even over ten-year periods. Monthly rolling ten-year AACRs reached their highest point this cycle in December 2021 at 10.4%, which was the strongest ten-year return since the period ended December 2006. The 2021 year-end mark coincided with the height of the 2011 European Sovereign Debt Crisis—when Eurozone stocks returned -15.2%—rolling out of the data set, reinforcing that even longer-term return views can be skewed by short-term market fluctuations.
Eurozone equities, bonds, and cash all outpaced inflation over very long-term periods, based on data since the mid-20th century. Across all rolling 50-year periods since 1951, real AACRs for Eurozone stocks ranged from 3.7% to 8.7%, outpacing inflation by the widest margin. Eurozone bonds and cash also gained in real terms, with returns ranging from 1.8% to 3.5% and from 0.3% to 0.8%, respectively. Benchmark Eurozone government bonds and cash produced full-period AACRs of 5.3% and 3.6%, respectively, since 1950, which represents a significantly narrower spread vis-à-vis the average inflation rate of 3.8% per annum. Still, given that euro area inflation remains above the yield on offer for core ten-year government bonds, investors may struggle to earn a positive real return in the near term.
Over the long term, Eurozone equity investors are typically compensated for the additional risk of holding stocks. Since 1950, Eurozone equity returns exceeded bond returns during 69% of all five-year periods, 77% 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, underperformance over rolling five-year periods is not uncommon, as equities are prone to larger drawdowns than bonds. Such periods are a reminder of the ballast that fixed income allocations have traditionally provided portfolios. Investor’s experience in 2022 challenged this conventional wisdom, although the key differentiator in this episode was that bond yields started at historically low levels. In such cases, investors may need to consider other avenues to effectively diversify portfolios.
Earnings growth and dividend reinvestment are the primary contributors to equity total return over time, while valuation multiple rerating is ultimately negligible due to mean reversion. 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 the magnitude of their contribution is weaker, coming in at just half of the contribution provided by earnings. The primary driver of performance so far this decade
(2020–22) has been earnings growth, as the strong earnings rebound in 2021 and 2022 more than offset the pandemic-driven earnings contraction in 2020.
Starting valuations are a useful indicator for long-term (ten+ years) subsequent equity returns. 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 73% of the variation in subsequent ten-year real returns, a strong yet imperfect guide to future performance. At year-end 2022, Europe ex UK equity valuations ended in the 70th percentile of historical observations. When Europe ex UK valuations have been between the 25th percentile and 75th percentile, the median subsequent real return has been 6.1% annualized.
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.
Equity dividend yields are an important driver of total returns but are not a useful valuation indicator. For Europe ex UK stocks, 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. Dividend yields are currently in the 43rd percentile of the historical distribution, where subsequent real ten-year returns have been about 5% annualized. Dividend yields fail to capture the whole picture, however, as many other factors influence equity market returns. Still, 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, even as earnings contracted in these periods given their sensitivity to the economic cycle.
Subsequent nominal ten-year Eurozone bond returns closely track the starting yield, suggesting that yields are a reasonable proxy for forward return expectations. Since hitting all-time lows in December 2020, Eurozone ten-year bond yields have climbed more than 340 bps, ending 2022 at 3.15%, which has improved their forward return prospects. In fact, when yields historically were +/- 50 bps from today’s starting levels, subsequent nominal ten-year AACRs notched a median of around 5% annualized. Falling yields were a boon for European bond investors over the past 40 years, with Eurozone bonds returning 6.1% annualized since 1981, but that paradigm reversed sharply in 2022. While bonds proved to be a poor diversifier, given their low yields heading into today’s environment, future returns are likely to look better given the steep backup in yields.
There is a distinct inverse relationship between the level of government bond yields and equity 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 only 44% of the variation in equity market valuations. The relationship is not universal, however, and there are periods when equity valuations and yields have moved together. For example, in the early 2000s period preceding the Global Financial Crisis (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. Inflation’s impact on Eurozone equity returns is unclear. Median stock performance was 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 historically higher yield levels helped offset capital losses as bond prices fell. However, bond markets do suffer in real terms when consumer price levels increase 3% annualized or more.