1.
Global Research
Record low government bond yields, slower global growth and weak
demographic outlook point to disappointing 10-year equity returns.
This leaves Emerging Markets a structurally favoured asset class.
In a growth-starved world with historically low bond yields, equity markets that can
benefit from faster growth, higher bond yields and improving demographics should
command an even greater premium in the coming years. This report looks at how 10
Emerging, and 10 Developed Markets stack up on a 10-year horizon according to these
three key drivers of long-run returns.
Emerging Markets have enjoyed the best demographic trends over the past 25 years and
this trend should continue in the coming decades, according to United Nations projections.
On this basis, the standouts are South Africa, India and Mexico, which are projected to
see the biggest reduction in old-age dependency and increase in prime savers as well as
the fastest growth in urbanisation until 2035. The Philippines is also expected to join this
list after previously experiencing some of the world‟s worst demographic changes.
The US, Canada, Japan, Hong Kong, Korea and Switzerland are now expected to see
some of the worst trends in the coming decades. Canada may potentially be one of the
biggest losers from this shift as it had seen some of the best long-run equity returns
accompany some of the best demographics trends.
However, better demographics are no guarantee of stronger economic growth or equity
performance. For instance, South Africa‟s high unemployment and political woes prevent
the country from enjoying much of its “democratic dividend”. This puts an even greater
emphasis on identifying markets that have delivered on this potential through better
earnings and equity performance as well as the ability to benefit from rising bond yields.
Putting all of these factors together produces the following “Top 5” list of countries with
the best long-run outlook for equity returns: India, Mexico, Taiwan, Thailand and the
Philippines. In contrast, the “Bottom 5” for the next decade are the US, Canada, Japan,
South Korea and Switzerland.
European markets are the wild card. Demographics trends, which had been among the
worst, at the cost of weaker equity performance, are not expected to deteriorate at such a
rate in future. IMF growth forecasts reflect an entrenched pessimism that might only be
shaken by the success of the current unconventional policy measures aimed at stimulating
growth or from reforms that manage to lead to an improvement in potential growth. Given
the failure to achieve either of these objectives in the past decade and the recent political
turmoil, there remains little cause for optimism in the region over the long run.
Wesley Fogel
Investment Strategist
+44 7860 264 902
fogel@hotmail.com
25 August 2016 Asset Allocation
Global
Navigator
Taking a long view
Asset Allocation
2. Disappointing global growth post the 2008/9 financial
crisis combined with a string of political and
economic shocks has left financial market sentiment
increasingly policy-driven. This environment -
dubbed the “new normal” - clouds the long-term
outlook for equities and government bonds.
However, there is nothing really „new‟ about the
support to risk assets that softer monetary policy has
been providing to both the Emerging and Developed
world, ever since US bond yields peaked in
September 1981. Chart 1 shows how three phases of
halving US yields have been associated with some of
the strongest US equity returns over this period.
Despite the support from lower rates, conventional
economic wisdom (still) has it that market prices
reflect underlying fundamentals and ultimately move
towards equilibrium, while near-term shocks are
random “noise” that will eventually be corrected.
Chart 1. US equities have enjoyed 3 phases of halving yields
Source: Bloomberg, Author’s calculations. 3 periods of falling US 10-year yield:
30/9/1981-4/3/1986, 4/3/1986-5/9/2002, 5/4/2010-10/8/2016.
While the structural decline in bond yields can partly
be explained by the taming of inflationary pressures,
the debate has shifted towards whether the scale of
monetary easing has in many instances gone too far.
The ever-larger scale of quantitative easing and the
move to negative-yielding government (& corporate!)
bonds amid torpid global economic growth have also
raised doubts about the effectiveness of such
unconventional policies. As a result, the concept of
reflexivity has moved to the heart of the debate about
what drives financial markets.
Reflexivity asserts that market prices influence
fundamentals, which in turn can change expectations;
the pattern repeats itself, pushing prices ever further
away from their long-run equilibrium until a point
where “boom” turns to “bust”.
The increasingly episodic and global nature of the
economic cycle combined with a rising correlation
within financial markets does help to explain why
reflexivity has been able to mount a credible
challenge to long-held market beliefs; the pressure on
the Chinese yuan following speculation around a
further US interest rate hike is a recent case in point.
Growing macro uncertainty has also led to a
heightened level of myopia among long-term
investors as “shock fatigue” effectively caps their
ability to lock up capital for extended periods. This
manifests itself in a seemingly irrational demand for
negative-yielding bonds and record levels of cash
holdings among global fund managers.
60
560
1060
1560
2060
2560
81 84 87 90 93 96 99 02 05 08 11 14
0
2
4
6
8
10
12
14
16
S&P 50 0
annualised
ret urn: 16 %
S&P 50 0
annualised
ret urn: 10 %
1. 19 8 1- 19 8 6 3 . 2 0 10 - 2 0 162 . 19 8 6 - 2 0 0 2
S&P 50 0
annualised
ret urn: 8 .6 %
S&P 50 0
(Left HS) U S 10 yr
( R ight HS)
1
2
3
Taking a long view
Negative yields and slower growth mean equities will disappoint
Demographic trends can help determine the winners and losers
Emerging Markets stand to benefit the most from expected trends
3. Chart 2. US equities have been the most consistent long-
term performers*
Source: Bloomberg, Author’s calculations. *Daily data starts in January 1990, in US$.
Chart 2 shows how this volatile backdrop has seen
leadership among equities shift dramatically over the
past decade (red bars) compared with the trend since
1990 (blue bars). Emerging Markets have seen some
of the biggest changes with returns in Saudi Arabia
(collapse in oil), Poland and the Czech Republic
(slower growth, lower yields, waning demographics)
falling fastest. Other EMs, including the Philippines
(faster growth) Taiwan and Thailand (faster growth,
better demographics), have seen among the biggest
improvements in equity performance.
It is also remarkable to observe that US equities have
managed to deliver the identical annualised return
(included reinvested dividends) of 7.8% over the past
10 and 25 years. Only Japan has managed to deliver
as stable a return profile over this period, although it
has struggled to move above a 1% return per year.
A persistent decline in yields is about the only thing
that Japan and the US have had in common in recent
decades, which should be enough to raise red flags
about the need to revise down long-term return
expectations, perhaps more so in the US given how
supportive a trend of lower rates has proven to be.
Precisely estimating 10-year equity returns is
infinitely more difficult than with government bonds.
However, it is possible to identify the key drivers of
equities over the past 25 years and then try to
understand the implications of how these trends
might evolve in the coming decade.
In a growth-starved world with historically low bond
yields, equity markets that can benefit from faster
growth, higher interest rates and improving
demographics should command an even greater
premium in the coming years.
This report attempts to address these issues for 20
countries (10 Emerging and 10 Developed), which
have the best quality and longest history available,
going as far back as 1990 wherever possible.
Taking each of the three factors above in turn, it is
possible to get a better understanding of long-term
drivers of equity returns and start to form a view on
the outlook for the next 10 years.
Demographics
Demographic trends help define long-run potential
economic growth and the associated investment
opportunities that certain trends are expected to bring.
Trends in the following key metrics from an equity
investment perspective are addressed in turn:
1. Prime savers - population aged 40-64
divided by the rest of the population).
2. Old-age dependency – population aged 65+
divided by the population aged 15-64.
3. Urbanisation - percentage of the population
residing in urban areas.
Since 1990, all three measures have seen improving
trends - increase in prime savers, falling old-age
dependency and growing urbanisation - helping to
underpin equity returns over the same period, with
some countries benefiting much more than others.
However, the coming decades are likely see much of
this positive catalyst fade, thus reinforcing the
message implied from historically low bond yields:
expected returns will need to be revised lower.
However, it should still be possible to differentiate
between markets based on future demographic trends,
according to United Nations (UN) projections.
15.4
13.2
13.0
12.9
11.9
10.5
10.2
9.8
9.7
9.5
7.4
7.3
7.0
6.7
6.7
6.2
5.5
3.7
0.4
4.9
-1.1
-2.4
5.0
7.1
-2.2
7.7
6.2
3.5
5.8
7.8
4.9
0.8
1.2
4.6
1.6
17.4
13.5
7.5
1.4-5
0
5
10
15
20
Mexico
CzechRep.
SaudiArabia
SouthAfrica
Australia
Poland
India
HongKong
Canada
Switzerland
US
Germany
Eurozone
France
Korea
UK
Philippines
Thailand
Taiwan
Japan
Average 10-year annualised
equity return, %
Latest 10-year annualised
equity return, %
"Fed put"?
4. Prime savers: risks of asset shedding
When the share of the population aged between 40
and 64 years old is falling then a country suffers from
asset shedding. The International Monetary Fund
(IMF) has previously identified US equity weakness
in the 1970s and early 1980s coinciding with a low
share of prime savers. The strength of equities during
the 1990s was then associated with a sharp increase
in the prime saving population1
.
When compared with the increase in prime savers in
the US since 1990, UN data shows the Emerging Asia
economies have enjoyed a much stronger tailwind
over the same period. Thailand, Korea, Taiwan and
Hong Kong all saw a faster increase in the share of
prime savers. Amid a broadly deteriorating outlook
for the share of prime savers, the most positive trends
are projected to be in Saudi Arabia, Mexico, India
and South Africa while Korea and Hong Kong
should see the biggest reversal of fortunes.
Chart 3. The share of prime savers is expected to fall in
many countries in the coming decades*
Source: Bloomberg, United Nations World Population Prospects: The 2015 Revision,
Author’s calculations. *Prime savers: population aged 40-64 divided by the rest of the
population.
Old-age dependency: a potential drag on growth
The world is expected to see the share of the
population older than 65 years increase from 12% to
38% by 2100, according to UN projections. After
remaining high across the globe for a lengthy period
of time, a widespread fall in fertility rates will help to
1
International Monetary Fund, Regional Economic
Outlook, Asia- Pacific, November 2008 (link)
encourage a more sustainable pattern of development
and also reduce pressures on the environment.
The IMF sees these developments placing public
finances of countries under pressure via two
channels: spending on age-related programs
(pensions and health) and slower economic growth2
.
It sees the fiscal consequences as potentially dire as
increases in spending potentially lead to
unsustainable public debts that require sharp cuts in
other spending or mean large tax increases that could
become a drag on economic growth.
Looking forward over the coming decades, chart 4
shows both the extent to which the pace of ageing
will both deteriorate and differentiate among a
number of major economies.
The most favoured on this basis are South Africa,
the Philippines, India, Saudi Arabia and Mexico,
which are expected to see the biggest improvement in
prime saver ratios. The most challenged economies
will be Hong Kong, Taiwan, Korea, Germany and
Thailand, most of which are also likely to see a
falling in the share of prime savers.
Chart 4. Old-age dependency ratios are projected to rise
even faster around the world in future years*
Source: Bloomberg, United Nations World Population Prospects: The 2015 Revision,
Author’s calculations. *Old-age dependency ratio: population aged 65+ divided by
population aged between 15 and 64.
2
IMF Staff Discussion Note: The Fiscal
Consequences of Shrinking Populations, October
2015 (link).
-20
-10
0
10
20
30
40
50
SaudiArabia
Mexico
India
SouthAfrica
Poland
Philippines
CzechRep.
Thailand
Taiwan
Japan
Australia
Europe
UK
US
Canada
Korea
Switzerland
France
Germany
HongKong
1990-2015 change
in prime savers, pp
2015-2035 projected change
in prime savers, pp
-5
0
5
10
15
20
25
30
35
SouthAfrica
Philippines
India
SaudiArabia
Mexico
Australia
UK
CzechRep.
France
US
Japan
Europe
Poland
Switzerland
Canada
Thailand
Germany
Korea
Taiwan
HongKong
1990-2015 change
in old age dependency ratio
2015-2035 projected change
in old age dependency
5. Urbanisation: growth catalyst
The world has become increasingly urban, with cities
currently home to just over half of the global
population, compared with 30% in 19503
. This trend
is expected to continue, with 66% expected to live in
cities by 2050, according to the UN. There will be an
increasing focus on this trend as nearly all of the 1.1
billion increase in global population projected over
the next 15 years is expected to occur in urban areas4
.
While it may not be certain if urbanisation causes
countries to grow faster or if faster growth causes
greater urbanisation, it is clear is that no country has
either achieved high incomes or rapid growth without
substantial, often quite rapid, urbanisation5
.
Chart 5. EM should continue to benefit from urbanisation*
Source: Bloomberg, United Nations World Population Prospects: The 2015 Revision,
Author’s calculations. *Percentage of Population at Mid-Year Residing in Urban Areas
by Major Area.
In the coming decades, Thailand, India, South
Africa and Taiwan are expected to see the fastest
pace of growth in urbanisation. Korea will see a sharp
slowdown in this trend along with Hong Kong as well
as Australia (see chart 5).
Demographics and equities
In order to see how each of these major demographic
trends have been associated with equity returns, the
3
United Nations 2014 Revision of World
Urbanization Prospects (link).
4
Urbanization, City Growth, and the New United
Nations Development Agenda. Cornerstone (link).
5
Ibid.
average ranking of all three trends are compared with
a ranking of equity market performance since 1990.
Long-term equity performance is expressed as the
daily average 10-year annualised total return in US
dollar terms, which is illustrated in chart 6.
Chart 6. Methodology for calculating long-run equity returns*
Source: Author’s calculations. *Daily data.
Chart 7 breaks into quadrants where the overall best
or worst demographic trends have accompanied the
strongest or weakest equity returns. The best
demographics and long-term equity returns have
mainly come in Emerging Markets: Mexico, Saudi
Arabia, South Africa and India. Canada is the only
Developed Market economy to have seen among the
strongest equity returns accompany some of the best
demographic trends. Developed Europe as well as
Japan and the Philippines have seen some of the
worst equity returns accompany poor demographics.
Chart 7. Demographics have had the biggest positive impact
on EM equities while this has been a drag on DM*
Source: Bloomberg, United Nations World Population Prospects: The 2015 Revision,
Author’s calculations. *Compares ranking of overall trends in old-age dependency,
prime-savers and urbanisation with the average 10-year annualised equity return in
US$ terms between January 1990-July 2016.
-5
0
5
10
15
20
25
Thailand
India
SouthAfrica
Taiwan
Europe
Mexico
Germany
France
Philippines
UK
Japan
Poland
SaudiArabia
Canada
US
Switzerland
Korea
CzechRep.
Australia
HongKong
1990-2015 change
in urbanisation rate
2015-2035 change
in urbanisation rate
Past10-year annualised equity market return
Average
2000 2016
IMPROVING DEMOGRAPHICS
& WEAKER EQUITY PERFORMANCE
US
Korea
Thailand
Taiwan
IMPROVING DEMOGRAPHICS
& STRONGER EQUITY PERFORMANCE
Mexico
Saudi Arabia
South Africa
India
Canada
DETERIORATING DEMOGRAPHICS
& WEAKER EQUITY PERFORMANCE
Germany
France
UK
Japan
Philippines
DETERIORATING DEMOGRAPHICS
& STRONGER EQUITY PERFORMANCE
Poland, Czech Rep.
Hong Kong
Australia
Switzerland
Oveall demographics& equityperformance:1990-2016
6. Conclusions
Many of the Emerging Markets that have enjoyed the
best demographic trends over the past 25 years are
expected to continue to be the biggest winners in the
coming decades. The standouts are South Africa,
India and Mexico, which are projected to see the
biggest reduction in old-age dependency and the
biggest increase in prime savers and urbanisation.
Chart 7 highlighted how all three counties had seen
their equity markets deliver some of the best long-run
returns at the same time as enjoying the best overall
demographic trends. This can help provide a key
support for future returns over the coming decade.
The Philippines is also expected to join this list after
having previously seeing some of the world‟s worst
demographics; this turnaround can potentially
provide a positive catalyst for risk assets as weaker
long-run equity performance had come with some of
worst demographic trends. This improving structural
trend can already bee seen in a stronger equity
performance in the Philippines over the past decade.
Chart 8. Emerging Markets will continue to enjoy the biggest
demographic benefits over the coming decades*
Source: Bloomberg, United Nations World Population Prospects: The 2015 Revision,
Author’s calculations.
Thailand and Taiwan are seen benefiting among the
most from growing urbanisation as well as a trend of
rising prime savers continuing to move in a positive
direction. Both equity markets have delivered some
of the weakest equity returns since 1990 despite a
positive demographic backdrop. Any further
improvement in demographic trends can help to
underpin better long-run equity returns, which can
already been seen in an improved performance over
the past 10 years.
Saudi Arabia, which has seen economic growth slow
sharply following the collapse in oil prices, is still
expected to benefit from the biggest decline in old-
age dependency and rise in prime savers, continuing a
positive trend. The Czech Republic, another major
equity underperformer over the past decade, is also
projected to see among the best trends in both
metrics, in contrast to having seen some of the worst
changes over the past two decades.
The US, Canada and Korea are now expected to see
some of the worst trends over the next 20 years, after
having enjoyed some of the best demographic
changes in the past. Canada may potentially be one of
the biggest losers from this shift as it has seen some
of the best equity returns accompany the best
demographics. The US and Korea, which had seen
among the weakest equity returns despite some the
best demographic changes, also look vulnerable.
Chart 9. Developed Markets are expected to see the worst
demographic trends over the next 20 years*
Source: Bloomberg, United Nations World Population Prospects: The 2015 Revision,
Author’s calculations.
Hong Kong, Japan and Switzerland are also expected
to continue to see some of the worst demographic
trends. Hong Kong and Switzerland may struggle the
most with this change after having managed to
deliver some of the best equity returns despite the
worst demographic changes since 1990.
Old-age
dependency
Urbanisation
Prime savers
Poland
GermanyFrance
UK
Australia
Saudi Arabia
Czech Rep.
South Africa
India
Mexico
Philippines Thailand
Taiwan
Best demographic trends: 2015-2035
Old-age
dependency
Urbanisation
Prime savers
France
Saudi Arabia
Czech Rep.
Poland
Thailand
Taiwan
Germany
US, Canada
Hong Kong
Japan, Korea
Switzerland UK
Australia
Worst demographic trends: 2015-2035
7. Economic growth
In the long-run, corporate earnings should be
expected to grow broadly in-line with aggregate
domestic economic activity. However, the increasing
internationalisation of trade combined with the
ongoing structural changes in the global economy
may lead the relationship between earnings and GDP
growth to change over time.
In addition, a demographic backdrop that is generally
expected to become less favourable combined with an
uneven and disappointing global recovery since the
2008/9 financial crisis means that growth delivery is
expected to become a major differentiating factor
behind equity performance in the coming years.
Where’s the growth?
Chart 10 shows how since 2006, Emerging Asia has
been the best at delivering both a faster economic
expansion as well as better growth in earnings-per-
share (EPS). India and the Philippines have been the
standouts with Hong Kong, Taiwan, Korea, Thailand
as well as Poland also among the strongest.
Chart 10. Emerging Asia economies have delivered the best
earnings and GDP growth over the past decade*
Source: Bloomberg, IMF, Author’s calculations. *Year-on-year change in 12-month
forward EPS and annual GDP growth.
Europe has seen some of the weakest EPS and
economic growth, with the UK, France and the Czech
Republic among the worst, in addition to Mexico,
South Africa and Australia.
The US, Japan and Germany are among the markets
to have seen earnings grow faster than their
respective domestic economies. A sizeable export-
dependency in both Japan and Germany can partly
explain this disparity while a surge in stock buybacks
may help to explain a relatively stronger EPS trend in
the US. It is important to note that neither of these
forces can be expected to remain as a strong a
compensating factor in the coming years.
Chart 11 shows how the IMF‟s latest long-term GDP
growth estimates merely reflect many of the major
trends observed over the past decade. This leaves
open the possibility for some predictable revisions to
follow in future.
Among the potential for upgrades are the Emerging
Asian markets including Thailand and Taiwan, which
are expected to see slower growth despite the
continued demographic improvements highlighted in
the previous section.
The Philippines and India are among the few
economies forecast to see the growth trend
accelerating from already very strong levels. Given
the global decoupling that would be needed to
achieve such a growth outcome, there is some scope
for downward revisions in future, especially if the
pace of political reforms were to falter.
Chart 11. Long-run global growth expectations are always
subject to change!
Source: Author’s calculations, IMF
The growth forecasts for most of Europe and Japan
reflect an entrenched pessimism that might only be
shaken by the success of the current unconventional
Hong Kong
Taiwan
France
Japan
Europe
Germany
US
Korea
Canada
Poland
Czech Rep.
South Africa Switzerland
Thailand
Mexico
UK
Philippines
Australia
Saudi Arabia
India
0%
1%
2%
3%
4%
5%
6%
7%
-2% 0% 2% 4% 6% 8% 10% 12% 14% 16%
Strong GDP/Strong EPS
Weak GDP/Weak EPS
Weak GDP/Strong EPS
StrongGDP/Weak EPS
Average annual EPS growth since 2006
AverageannualGDPgrowthsince2006
Australia
Canada CzechFrance
Germany
Hong Kong
India
Japan
Korea
Mexico
Philippines
Poland
Saudi Arabia
S. Africa
Switzerland
Taiwan
Thailand
UK
US
Europe
0
1
2
3
4
5
6
7
8
0 1 2 3 4 5 6 7
Average annual GDP growth1990-2016
AverageannualGDPgrowth2016-2021est.
8. policy measures aimed at stimulating growth or from
reforms that manage to lead to an improvement in
potential growth. Given the failure to achieve either
of these objectives for more than two decades in
Japan and for the past decade in Europe, there
remains little cause for optimism especially given the
demographic headwinds already highlighted.
Growth and equities
The comprehensive historical study of Dimson,
Marsh & Staunton finds little, if any, long-term
relationship between real equity returns and economic
growth6
. Just as important is the price investors must
pay for this growth.
As Chart 12 shows, many of the Emerging Asia
economies that are expected to achieve some of the
fastest GDP growth in the coming years currently
trade at premiums to their respective 10-year average.
Chart 12. European and US equity valuations look rich
compared with EM Asia*
Source: Bloomberg, Author’s calculations, IMF. Daily 12-month forward P/E data.
However, the US, Canada, Australia and developed
European markets also trade at similar premiums
despite a much weaker growth outlook, leaving these
markets vulnerable to future derating. Japan, South
Africa and the Czech Republic, which are expected to
see growth remain sluggish in the coming years,
already show the biggest discounts.
6
Triumph of the Optimists: 101 Years of Global
Investment Returns, Elroy Dimson, Paul Marsh, &
Mike Staunton, 2002.
Contrary to the findings of Dimson et al., slowing
global growth over the past decade has helped foster
an environment whereby faster earnings growth has
been rewarded with better equity returns. Chart 13
shows how EM Asia has been the biggest beneficiary
of this trend while Europe, Canada and South Africa
have been punished the most.
Japan has been one of the biggest outliers as faster
earnings growth has failed to translate into better
equity performance. The extent to which currency
weakness has provided support to earnings in the past
highlights the limited extent to which this approach
translates into sustained equity market performance.
Chart 13. EM Asia has seen stronger earnings and equity
performance over the past decade vs. Europe*
Source: Author’s calculations, IMF. *
Conclusions
Equities remain vulnerable both in the medium-term,
given the current late cycle stage of the global
economic cycle, as well as over the long-term as
structural growth drivers become a headwind. As a
result the equity investor will increasingly need to
focus on markets where growth and earnings delivery
are likely to be the strongest.
While there isn‟t a proven relationship between
economic growth and earnings, it is important to
observe that over the past decade, equity markets in
countries with both faster GDP and EPS growth have
seen some of the best equity returns and currently
trade at some of the biggest valuation premiums.
Mexico
South Africa
Saudi Arabia
India
Thailand
Poland
Australia
Taiwan
US
Philippines
Canada
Czech Rep.
Switzerland
Eurozone
Korea
UK
Hong Kong
France
Germany
Japan
-35%
-25%
-15%
-5%
5%
15%
25%
35%
45%
0% 1% 2% 3% 4% 5% 6% 7%
12mFwdP/Ediscount/premiumvs.10-yearaverage)
Average annual GDP growth2016-2021 est.
Weak GDP/expensive equities Strong GDP/expensive equities
Weak GDP/cheap equities
Mexico
South Africa
Saudi Arabia
India
Thailand
Poland
Australia
Taiwan
US
Philippines
Canada
Czech Rep.
Switzerland
Eurozone
Korea
UK
Hong Kong
France
Germany
Japan
-2
0
2
4
6
8
10
12
14
-5 0 5 10 15 20
Strong EPS/Strong equity performance
Weak EPS/
Weak equity performance
Annualised equity total return 2006-2016
AverageannualEPSgrowth:2006-2016
9. Equity markets returns in 2016 have so far been
mostly driven by multiple expansion (see chart 14)
although positive earnings momentum has also
contributed towards this performance across most
major EMs (excluding Saudi Arabia and the Czech
Republic). The coming decade can be expected to see
the trend of rewarding earnings momentum with
stronger equity returns and higher premium continue.
Chart 14. Multiple expansion has driven most of the gains in
equity markets during 2016
Source: Bloomberg, Author’s calculations. Data until August 21th 2016.
Government bond yields
Persistent doubts about the future path of benchmark
bond yields from record low levels presents a further
medium-term challenge for equity investors and helps
to explain much of the recent myopic shift in the
investment strategy process.
Any upward, or worse, sudden, normalisation would
put a higher discount rate underneath currently lofty
valuations highlighted in chart 12 on the previous
page, while a decline from historically low levels
implies the further need to revise down growth
expectations, threatening the equity market outlook.
How long is a piece of string?
It is almost exactly 35 years since US bond yields
peaked and the following structural decline was
initially accompanied by a number of benign trends
across many other Developed and Emerging Markets
as inflation slowed from double-digit levels.
The turn of the century saw the biggest decline in EM
as a step-change in political and economic stability
heralded a period of stronger China-led growth and
slower inflation.
The past decade has seen DM bond yields fall faster
as slower inflation has been accompanied by sluggish
global economic growth, recently bringing negative
rates to an increasing number of countries.
As a result, the average 10-year yield among the 10
EMs studied in this report is now 3.6%, less than 100
basis points from the average historical low. DMs
now have an average yield of 0.6%, only 16bp above
their multi-decade lows (see chart 15).
Chart 15. Global bond yields are close to record lows*
Source: Bloomberg, Author’s calculations. *Data from January 1990 where possible as
of August 21st 2016.
The open desire of the US Federal Reserve to hike
rates over the coming quarters still goes against the
grain as the rest of the world moves towards even
looser monetary policy in 2016 and, potentially,
beyond. So far this year, 17 major central banks have
cut interest rates after 19 moved lower in 2015.
Some EM central banks have been tightening policy,
although this has usually been to defend its currency
and fend off faster inflation (e.g. South Africa and
Mexico), which further complicates the Fed‟s
objective given that it now explicitly acknowledges
global factors in its decision-making process.
Indeed, expanding QE and negative interest rates
failing to generate 2% inflation has brought the entire
inflation-targeting framework into question. An
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0%
5%
10%
15%
20%
25%
30%
Thailand
Canada
Philippines
SouthAfrica
Taiwan
Korea
Australia
Mexico
Poland
US
India
HongKong
Germany
Japan
France
UK
Switzerland
Eurozone
CzechRep.
SaudiArabia
Conttributon toyear-to-date equity performance US$):
12m fwd P/E % change
12m fwd EPS % change
12m fwd dividend yield
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SouthAfrica
India
Mexico
SaudiArabia
Philippines
Poland
Thailand
Australia
US
Korea
Canada
HongKong
Taiwan
UK
CzechRep.
France
Germany
Eurozone
Japan
Switzerland
Historical
range
Latest 10-year yield, %
10. important factor behind the failure to generate faster
inflation has been the collapse in oil prices following
a shift in strategy by Saudi-led OPEC two years ago.
As the Saudi‟s continue balance market share with a
transition to less oil dependence, a low oil price
environment can be expected to continue for the
foreseeable future.
As chart 16 shows, much of the trend in US inflation
can be explained by the year-on-year change oil
prices. Assuming oil prices remain at $45 or even
$50/bbl for the next 12 months, it would still be
difficult for inflation to exceed 2% for very long.
Chart 16. US inflation set to accelerate even with little
change in oil prices
Source: Bloomberg, Author’s calculations.
With monetary policy increasingly seen “pushing on
a string”, and given the slower growth and weaker
demographic backdrop that is likely over the coming
years, the threat of higher bond yields remains
unlikely to create the major headwind for equity
investors in the medium-term. Indeed, EM equity
markets stand to benefit the most from the hunt for
yield given an attractive EM/DM bond yield spread.
Bond yields and equities
Still, from such a historically low level, there is a
limit to how much further these rates can, or will,
move lower. It is therefore important to understand
which markets have benefited the most from a falling
rate environment and hence will enjoy less benefit
from this trend in the future.
Chart 17 compares the correlation between daily
rolling 10-year bond yields changes and 10-year
equity returns during 1990-2016 and since 2012. This
shows EM Asia, Australia and the Czech Republic
in the top-right quadrant as the most consistent
beneficiaries from a rising rate environment. In
contrast, Mexico and Saudi Arabia have seen equities
benefit the most from a falling rate environment.
The past few years has seen the biggest change in the
US and Developed European markets, where growth
has become more disappointing. As a result, these
equity markets have benefited more from a rising rate
environment than was the case in past decades.
Canada, Hong Kong, Poland, South Africa and the
Philippines have been benefiting less from rising
rates than in the past. A mixture of political risk and
sluggish growth now leaves these equity markets
especially vulnerable to a rising rate environment.
Chart 17. Asia-Pacific and Developed Europe equities the
biggest beneficiaries of higher bond yields*
Source: Bloomberg, Author’s calculations. * Correlation between 10-year change in
bond yields and 10-year annualised equity returns in US$ using daily data over the
period January 1990 (where possible) and July 2016.
Conclusions
The Fed‟s “dovish tightening” approach to raising
rates is expected to continue over the coming
quarters, which will give rise to some inevitable bouts
of volatility in both equities and fixed income
markets. While spikes in yields can be expected, the
overall move upwards will be gradual and hence
should not become a major headwind for risk assets.
-3%
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0%
1%
2%
3%
4%
5%
6%
-150%
-100%
-50%
0%
50%
100%
150%
00 02 04 06 08 10 12 14 16
US inflation , YoY change
(Right HS)
Brent oil, YoY change
(Left HS)
Brent oil, YoY change
if oil price next 12m :
$45/bbl
$50/bbl
India
Japan
Hong Kong
Taiwan
Thailand
Czech Rep.
Australia
Korea
Poland
Philippines
Canada
US
Saudi Arabia
Switzerland
Eurozone
Mexico
France
UK Germany
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30%
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-60% -40% -20% 0% 20% 40% 60% 80% 100%
Equities consistently benefit
from rising yields
2012-2016correlationbetweenequitiesandbondyields
1990-2016 correlation between equities and bond yields
Equities consistently benefit
from falling yields
Equities benefiting less
from rising yields since 2012
Equities benefiting more
from rising yields since 2012
S. Africa
11. Conclusions
Improving demographics don‟t always result in faster
economic growth and improving economic growth
won‟t always lead to faster earnings growth. This
makes forecasting 10-year equity returns especially
challenging given the ongoing structural changes
taking place in the global economy.
What is increasingly clear is that markets will
continue to be driven by the hunt for yield and
growth. Concerns over an ongoing sluggish recovery
post the 2008/9 financial crisis, the limits to what
monetary and fiscal policy can achieve (on their own)
as well as a deteriorating demographic outlook all
stand to weigh on equity returns over the next decade.
A direct consequence of this fragile macro backdrop,
will be an even greater focus on markets that can
deliver growth and where rising bond yields are
supportive to equities.
On the basis of these criteria, India, Mexico,
Taiwan, Thailand and the Philippines look the
strongest for the next decade.
In contrast, the US, Canada, Japan, South Korea
and Switzerland look to be the weakest over a 10-
year horizon.
A cornerstone of this debate is whether near-record low bond yields have
become a symptom (aka “Japanification”) or a cure (conventional monetary
stimulus) of the uneven and disappointing global economic growth that has
followed the 2008/9 financial crisis.
Chart 18. Bond yield spread between top 5 and bottom 5
markets the highest in over a decade
Source: Bloomberg, Author’s calculations. Top 5: US, Canada, Japan, South Korea and
Switzerland. Bottom 5: India, Mexico, Taiwan, Thailand and the Philippines. Equal-
weighted baskets.
Creating an equal-weighted basket of each group
highlights the potential for these markets to diverge in
the coming years. Chart 18 shows how the move in
local currency bond yields over the past few years
reflects the disparity in 10-year outlook; the spread
between the average yield of the top 5 and the bottom
5 is now close to the highest in a decade.
While bond yields have diverged, long-term equity
returns (as per the methodology shown in chart 6 on
p. 5) for both groups have modestly converged.
However, chart 19 shows how the additional equity
return generated by the top 5 has stayed roughly
constant at an annualised 5% since 2013 even as the
bond yield differential has risen over the same period.
Chart 19. Top 5 vs. bottom 5 equity performance differential
has stayed roughly unchanged since 2013*
Source: Bloomberg, Author’s calculations. *Equity return is average annualised 10-year
return in US$ using daily data since 1990. Top 5: US, Canada, Japan, South Korea and
Switzerland. Bottom 5: India, Mexico, Taiwan, Thailand and the Philippines. Equal-
weighted baskets.
A continued hunt for yield that should ensure bonds
are well bid among the top 5, as well as the potential
growth disparity are both key long-term ingredients
that can help ensure equity performance differentials
between the top and bottom 5 widens further in
coming years.
This relatively more constructive view on the top 5 is
reinforced by the scale of the decline in long-run
returns in excess of 10-year bond yields, as shown in
chart 20.
This highlights that equities returns have fallen faster
than the decline in bond yields since 2013 in both
groups, but more so among the top 5. This leaves the
“equity risk premium” (ERP) of the top 5 relative to
the bottom 5 at the lowest since 2008. Given the
potential for spread compression in bond yields, there
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01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
50
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200
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400Top 5 bond yields
(Left HS, %)
B ot t om 5 bond yields
(Left HS, %)
Top 5/ bot t om 5 dif erent ial
(Right HS, bp)
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25
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Top 5 equit y ret urns
(Left HS, %)
B ot t om 5 equit y ret urns
(Left HS, %)
Top 5/ bot t om 5 dif erent ial
(Right HS, bp)
12. is significant scope for this ERP differential to widen
much further in the coming years. Until we reach the
levels last seen in 2010, the case for being structurally
overweight Emerging Markets and underweight
Developed Markets will remain in tact for both
equities and fixed income.
Chart 20. Equity risk premium of the top 5 has fallen sharply
relative to the bottom 5
Source: Bloomberg, Author’s calculations. Top 5: US, Canada, Japan, South Korea and
Switzerland. Bottom 5: India, Mexico, Taiwan, Thailand and the Philippines. Equal-
weighted baskets.
Wesley Fogel
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Top 5 equit y ret urn
vs. local 10 yr bond yield
(Left HS, %)
Top 5 equit y ret urn
vs. local 10 - yrbond yield
(Left HS, %)
Top 5/ bot t om 5 dif erent ial
(Right HS, bp)
