Intuitively, the current market environment appears to paint an ambiguous picture for future equity returns. On the one hand, uncertainty about the outlook for economic growth should have a negative impact on equity returns. It should be more difficult, after all, for companies to make profits and to invest if the economy is on a rollercoaster ride between expansion and recession and nobody can really foresee what the future holds.
On the other hand, low interest rates could also be positive for equity returns. Low rates should make equities more attractive vis-à-vis other asset classes for a number of reasons. Let’s consider three of them: If rates have plummeted and investors earn an effective return of zero on bonds or cash, equities offering the opportunity to earn dividends and (possibly) benefit from rising share prices look like a better investment. It would also be cheaper for investors to borrow cash to buy shares. Last but not least, lower interest rates should also help kick start economic growth, thereby creating an environment that is more conducive to high equity returns.
As many a times, a bit of market history (and statistics) can be useful for understanding which of these two factors has had the bigger impact historically. The Economist recently published some analysis to address precisely this question – the original piece can be found here. The Economist used data going back to 1926 from the Barclays Capital Equity-Gilt Study to see how American equities performed in real terms (i.e. taking into account inflation) in low interest rate environments. The picture which emerged was pretty clear: equity returns are about two thirds lower when real interest rates are negative. Additionally, the worst equity underperformance occurred during the years with the lowest real interest rates. This shows that very low interest rates are a sign that the economy is in serious trouble rather than a bullish market signal.
We have run the same analysis for UK equities, using data going back to 1900 which has also been taken from the Barclays Capital Equity-Gilt Study. We proxied real interest rates by subtracting realised inflation from the realised yield on a gilt index (both figures are published in the Barclays Study). Consequently, real interest rates are negative when inflation is higher than the yield on the gilt index.
The result is pretty much the same: real equity returns are lower when inflation-adjusted yields on gilts are negative. During years with positive gilt yields, equities on average returned 2.60% in real terms per year. When yields were negative, they returned only 1.30% p.a.
When real gilt yields are grouped into quintiles – e.g. the lowest quintile covers the years with the bottom 20% of real gilt yields whereas the top quintile comprises the years with the highest 20% of real gilt yields etc. – the result is also the same as for the American stock market. The lowest equity returns occurred during the bottom quintile of real gilt yields. The chart below summarises the results.
Note that the average real equity return for the bottom quintile is only positive because of the stellar performance of the UK stock market in 1974, when equities returned almost 90% in real terms. If this outlier is excluded, the average annual return for the bottom quintile falls to minus 3.97%. In contrast, the average annual real return on equities for the top quintile of real gilt yields is 6.70%. There is therefore a wide spread between stock market returns in a low yield environment and a high yield environment.
History therefore suggests that a low interest rate environment is not conducive to high equity returns, at least in the short run. Very low interest rates are a sign that the economy is in crisis mode, that central banks have been easing monetary policy to avert disaster and that companies are not looking to invest (which would lead to higher interest rates as it increases demand for capital) because they cannot be sure that their investments will be profitable in a volatile, low-growth environment.
Of course, one could argue that by focussing on one-year returns we are missing out the bigger, longer-term return picture. A negative real yield environment may be an excellent opportunity to invest into equities because they provide attractive returns over the next five or even ten years. However, some statistical analysis shows that there does not seem to be a significant link between the yields prevailing in a given year and cumulative real equity returns over the next five or ten years. In other words, the chance to earn high equity returns in the longer run if one buys shares in a low interest rate environment is pretty much the same as the chance of heads coming up in a coin toss. Whilst statistically ‘fair’, this is perhaps not the sort of probability on which one wants to base an investment strategy.
The analysis implies that equity investors may want to brace themselves for disappointing stock market returns in the short term despite record low interest rates. More worryingly, it also means that pension funds which are underfunded should not blindly hope that stellar equity outperformance will help them to improve their funding levels quickly.