For an entire generation of investors, the market has been underpinned by falling rates, increasing leverage, and relative geopolitical stability. But today all those tailwinds are becoming headwinds. Adrian Warner, Managing Director and CIO of Avenir Capital lays out the challenge ahead and a strategy to tackle it.
In this fascinating video (with transcript), Adrian tells us that investors need to reset their expectations for returns over the next ten years: “We're in the top decile of equity valuations historically. From this point, typically equity returns over the next 10 years are 1 or 2 per cent”. While equities could be hamstrung for some time, Adrian says “there are still, as always, plenty of opportunity within that to make really good returns”. Hear how.
If we look at a Shiller P/E, which is a 10 year average P/E which tries to smooth out the cyclical elements of the market price, in the early 80’s the Shiller P/E was about 7. It was single digits, firmly in the single digits. By 1990’s it was about 16 or mid teens. Now we're over 30. Now that's a very different place to start when you look forward for the next 10 years.
Interest rates in the early 90s were in double digits, they got up to mid-teens rates. And they've been trending down ever since until very recently we were below 2% on long term government bonds in the US. And so, we've had this huge tailwind of declining interest rates which means people could borrow more, they could finance more, they could afford to pay more for assets, whether it's property, infrastructure, or companies. As those interest rates have come down, the competition for other assets has declined and so you could afford to, if you're only making 2% on a 10 year bond, you can afford to only get a 4 or 5% yield on property or infrastructure.
So we've gone from a very attractive starting point and had a very attractive period of 20 or 30 years and we're now at a very unattractive starting point with high equity prices and very low interest rates which are likely to go up from here.
And we're also at a point where the geopolitical scene is a lot less settled now where despite, or, as opposed to the US having this hegemony for many years, we've now got these significant foreign counterparties, they're jockeying for position which creates turbulence and friction. We've got increasing nationalism, populism, protectionism around the world. And you see that time and time again from the Brexit vote in the UK, from the rise of Trump in the US, President Xi in China getting essentially unlimited term, President Putin in Russia getting stronger and stronger. And this kind of increase in geopolitical disquiet, if you like, an increase in economic and literally might from other players globally, I think is less conducive to a harmonious economic existence than we've seen for the last 30 years.
Investors should adjust their expectations
So we just think people's expectations for returns over the next 10 years should be moderated compared to what they've been used to over the last 30 years. We're in the top decile of equity evaluations historically and from this point, typically equity returns over the next 10 years are 1 or 2 percent.
People need to think about the next 10 years in a different way than they've become accustomed to over the last 30 and the tailwind of increasing asset prices will not continue. And I think the next 10 years are going to require more selectively focusing on opportunity sets to generate those kind of excess returns.
How can investors navigate these structural shifts?
Equity markets can go sideways for a very long time. And from about 2000 to about 2013 the equity market did nothing. There were lots of ups and downs along that journey, and lots of opportunity within the index to make money.
But I think when people are investing in a passive sense or in a broad based index driven approach, 12 to 13 years is a very long time to be treading water and it can get very frustrating.
But we think even in that kind of period, there are lots of opportunities within that, and we've talked in the past about how even in big indices like the S&P 500, the biggest most powerful companies in the world, a third of those companies every year, and it happens every year, will see a 50% or greater variation in their price in that 12 month period. Three quarters of them will see a 30% or more price variation in that period. And their underlying values are not swinging by that much over a 12-month period.
So we think there's lots of opportunity to go off the beaten track a bit, to try to find opportunities to take a differentiated view from the market or to take advantage of market volatility or company specific volatility by really understanding the company, understanding the fundamentals and being very selective about where you put capital rather than just being exposed to a broad asset class.
And I think that broad asset class exposure, I think may disappoint people over the next 10 years but there's still, as always, plenty of opportunity within that to make really good returns.