The COVID-19 pandemic and lockdown measures imposed across the globe to combat the virus’ spread caused historic declines in economic activity and sharp movements in asset prices during 2020. In first quarter, the FTSE All-Share Index declined 36% in just 46 trading days, sending market volatility to levels only observed in prior periods of market stress such as the Great Inflation of the mid-1970s, the Black Monday crash of 1987, and the Global Financial Crisis (GFC) of 2008–09. UK equities were further buffeted by Brexit uncertainty and subsequent efforts to contain new virus variants. However, UK stocks finished 2020 down only 9.8%, having rebounded 35% from their pandemic nadir, as Brexit uncertainties waned, fiscal and monetary policy remained highly accommodative, and an unprecedented vaccine development and distribution effort brought forward the prospect of a sooner-than-expected return to economic normalcy. If the rebound continues and equities regain prior peaks in 2021, it would mark a historically speedy recovery. By comparison, UK stocks took 1,052 days and 1,540 days to recover from the 1987 crash and GFC, respectively.
The real economy also suffered unparalleled setbacks. Real GDP in second quarter 2020 plummeted 19.0% quarter-over-quarter, the steepest decline since at least 1955 when comparable records begin. The GDP decline was driven largely by consumer spending, which fell more than 20%—also the largest decline on record. Virus containment measures toppled manufacturing activity as well, with industrial production falling more than 20% year-over-year in April 2020. Indeed, the economy has rebounded from the worst of the economic crisis, but many indicators remain well below their pre-pandemic levels.
There are many reasons why economic cycles can turn, including aggregate supply/demand shocks, financial market spillover to the real economy, and psychological factors. The COVID-19 crisis is unique in that it created shocks on three fronts: supply, demand, and financial. Lockdown measures that imposed curbs on daily life impacted aggregate supply/demand, while lack of liquidity and seizing credit roiled financial markets. Even before the COVID-19 pandemic, there were signs the business cycle had grown overextended. By late 2019, the labor market had tightened with unemployment reaching multi-decade lows, pushing wage growth to decade highs, and the Bank of England had raised benchmark interest rates twice since 2017. Additionally, the UK yield curve—a widely viewed indicator of the economic cycle—inverted, signaling heightened risk of an economic slowdown.
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.
Recent UK equity returns have struggled to keep up with their long-term average. Investors in UK equities have earned a nominal average annual compound return (AACR) of 5.6% over the past ten years. For the full period analyzed (1900–2020), UK equities have posted a nominal AACR of 8.6%. However, timing mattered: monthly rolling ten-year AACRs reached their highest point this cycle in February 2019 at 11.2%, which was the strongest ten-year return period since the period ending March 2002. The February peak coincided with the ten-year horizon when the largest declines during the GFC fell out of the data set, beginning in March 2009 when the FTSE All-Share Index hit its bottom. This highlights the impact of beginning- and end-point sensitivity, and reminds investors that even over periods as long as ten years, returns can be skewed by short-term market fluctuations. Above-average performance proved to be short-lived, however, as trailing ten-year returns for UK equities have been below their long-term average since August 2019.
Equities are most likely to outpace inflation over long-term periods, generating positive inflation-adjusted returns at the lower end of the returns range. Over rolling 50-year periods, real AACRs for UK stocks ranged from 2.0% to 8.2%, whereas the range for benchmark government bonds (-1.8% to 3.5%) and cash (-1.1% to 2.0%) indicated greater potential for diminished purchasing power over certain periods. Equities, however, never lost out to inflation over the very long term. Inflation in the United Kingdom has averaged 3.7% annually, roughly in line with other developed economies. Benchmark UK government bonds and cash produced full-period AACRs of 5.1% and 4.5%, respectively, since 1900, which is a significantly narrower spread vis-à-vis inflation relative to stocks versus inflation. Interestingly, UK government bonds had a lower minimum real return over the very long term relative to cash, likely a result of greater duration risk inherent in bonds versus cash.
Over the long term, UK equity investors have a high probability of being compensated for the additional risk of holding stocks. Since 1900, UK equity returns exceeded bond returns during 72% of all five-year periods, 76% of all ten-year periods, and 93% of all 25-year periods (calculated on a nominal basis using rolling monthly data). While equities tend to outperform in the long term, since 1900, 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 have provided to portfolios in terms of diversification, though today’s historically low-yield environment has challenged this conventional wisdom.
Earnings growth and dividend reinvestment, respectively, are the primary contributors to equity total return over time, while valuation mean reversion diminishes the impact of multiple rerating. Earnings growth provided the highest degree of return contribution, on average, but can be highly volatile (especially during periods of economic decline) relative to the steady stream of reliable income provided by dividends. In 2020, earnings contracted significantly, outweighing the positive return contribution from multiple expansion and dividend reinvestment. Dividend reinvestment’s contribution to UK equity performance has been more stable relative to the United States, but has declined somewhat over time as share buybacks have become more prominent. In the past two decades, dividend reinvestment averaged 3.5% versus 5.0% in the four-decade period from 1960 to 1999. Over the full historical period, dividend reinvestment averaged 4.4%.
Starting valuations are a useful indicator for long-term (ten+ years) subsequent equity returns, but the relationship is 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 the United Kingdom has explained 76% of the variation in subsequent ten-year real returns, a moderately strong yet imperfect guide to future returns. At December 31, 2020, UK equity valuations ended in the 15th percentile of historical observations, and from these valuation levels, the median subsequent ten-year real return for UK equities has been about 9% annualized.
High- or low-valuation environments alone are not a catalyst for market reversals and may persist for several years; waiting for valuations to revert to mean can be an exercise in frustration. UK equities provide a fitting example; since mid-2008, valuations have been below the 50th percentile 98% of the time, based on our CAPCE ratio distribution dating back to the late 1970s. 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 UK 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 not as useful as normalized valuations when it comes to predicting subsequent performance, but starting dividend yields are consistent with the expected relative direction of future returns. In the United Kingdom, 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 28th percentile of the historical distribution, where subsequent real ten-year returns historically have been about 5% annualized. Dividend yields fail to capture the whole picture, however, as many other factors influence equity market returns. While dividend yields fall short in terms of forecasting ability, the importance of dividend reinvestment as a driver of total return should not be understated. In fact, since the 1960s, 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 UK bond returns generally track the starting yield, displaying a tighter fit since the 1960s. With bond yields at historical lows in the United Kingdom, the outlook for future returns is decidedly low. In July 2020, UK ten-year gilt yields fell to their lowest levels on record and ended the year at just 0.20%. There is no comparable period of such low yield levels in the United Kingdom, but if the strong correlation between starting yields and subsequent performance observed since the 1960s (correlation coefficient=0.97) is a guide, UK bond returns are very likely to be well below average in the ensuing ten years. Also, even low inflation could erode UK bond returns in real terms. While falling yields have been a boon for UK bond investors for the past 40+ years, with UK gilts returning 9.8% annualized since 1974, today’s low-yield environment may cap future returns. Such low yields today mean investors may need to consider other avenues for defensive portfolio diversification.
The relationship between the level of UK gilt yields and equity market valuations in the United Kingdom is unclear. Many have argued in recent years that high equity valuations, particularly in the United States, are justified (or at least in part explained) by low Treasury yields. The reasoning is fairly straightforward; when discount rates fall, the present value of future cash flows increases, thus pushing up valuations. However, this is not the case for UK equities. Despite a sustained gilt yield decline since the GFC, UK equity valuations have struggled to rise above their historical median. In fact, since 1979, ten-year UK gilt yields have explained only 8% of the variation in equity market valuations. The UK equity market’s composition—namely outsized exposure to value-oriented financials and natural resources–linked stocks—may help explain the depressed valuations in the post-crisis period. While there is a slightly negative relationship between gilt yields and equity market valuations overall, gilt yields have little explanatory power relative to equity market valuations. Given the historical evidence, 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. Given the extraordinary amount of fiscal and monetary stimulus extended in response to the COVID-19 crisis, asset markets have begun to price in expectations for inflation to rise, a dynamic commonly dubbed the “reflation trade.” This level of policy accommodation has also led investors to begin considering the possibility that inflation could surprise to the upside, potentially to levels last seen during the late 1970s/early 1980s era. Based on the historical record, UK equities fare best with inflation at moderate levels, exhibiting limited downside over rolling three-year periods when inflation ranges from 2.9% to 4.4%. However, the highest inflationary periods have created a volatile environment for stocks, with equities experiencing the lowest, but also highest, rolling three-year returns during top decile inflationary periods. In nominal terms, median bond performance remains positive during periods of high inflation, as higher yield levels help offset any capital losses as bond prices fall. However, bond markets do suffer in real terms during the highest bouts of inflation when price levels increase 5% annualized or more.