The following chart shows nominal total equity returns in local currency terms for select developed market countries from the beginning of January 1970 through the end of August 2013.
The UK is way out ahead of the pack, almost doubling the returns of the US and France, and more than quadrupling and octupling the returns of Germany and Japan. But most of the UK market’s nominal outperformance has been due to higher domestic inflation. The following chart shows the consumer price index for each economy:
The following table separates annualized returns for each country into nominal, inflation, and real:
Note that the sum of the annualized real returns and the annualized inflation rates are almost equal to, but not exactly equal to, the annualized nominal returns. This is just an artifact of the math.
The following chart shows the real total return for equities in each nation:
We can draw two conclusions from these charts. First, future nominal US and European equity returns are likely to be low relative to the past, and second, German equities are probably cheap relative to those of the US.
Future Nominal Returns Are Likely to Be Historically Low
As far as equity performance is concerned, inflation matters–a lot. Over the last 50 years, it has accounted for a little less than half of the total nominal returns of developed market equities.
Looking out into the future, developed economies face a number of anti-inflationary headwinds:
- Aging and shrinking population demographics, a secular trend that has emerged as a result of economic and medical progress and a general elevation of women’s status in society.
- Stagnation in opportunities for genuine, economic-value-adding innovation, and therefore in opportunities for real investment, which stimulate inflation by putting pressure on the supply and price of labor.
- Reduced bargaining power on the part of labor due to labor-displacing technological advancement and globalization.
Consequently, we can conclude that nominal total returns for developed market equities are likely to be meaningfully lower than they’ve been in the past.
German Equties are Probably Cheaper than US Equities
Justifications aside, the Germany equity market is probably more attractively valued right now than the US equity market. Let’s explore why this is likely to be true.
The “equity” (or total business value, understood not only in potentially inaccurate accounting terms, but also in real terms) contained in a share of a stock market trades at a certain price, and therefore at a certain valuation. The total return from any time T1 to any time T2 is the total profit generated by that share of equity (which is either reinvested internally, thus increasing per-share equity, or distributed to shareholders via dividends), plus any return that results from a change in valuation.
Now, ignoring differences in corporate taxes, if we assume that equity markets in two different countries start at time T1 at the same valuation, and proceed to generate the same return on equity from time T1 to time T2, then any difference in their total returns over the time period must be a consequence of changes in their relative valuations. The equity market that produced the lower total return must have become cheaper than the equity market that produced the higher total return, with its falling valuation being the very cause of its lower total return.
From 1970 to 2013, the total real return of German equities has been roughly 25% less than that of US equities. If we make the reasonable assumption that German equities were not already significantly more expensive than US equities in 1970, and that the return on equity of the corporate sector in each country has not been significantly different, then it would have to be true that German equities are presently cheaper than US equities.
It’s tempting to draw the same conclusion about Japan, given the dramatic underperformance of its equity market. I hesitate to draw this conclusion because Japanese corporations have been notorious destroyers of value over the last 25 years. Their relative underperformance can be attributed to relative differences in their return on equity. The same is not true, however, of German corporations, which tend to be just as well run and shareholder friendly as their US counterparts.
The conclusion that German equities are cheaper than US equities fits with the signals generated by other valuation measures. According to MSCI, Germany’s trailing twelve month price-earnings multiple is roughly 12, around 30% less than the US multiple of 17. Germany’s Shiller CAPE and price to book value are similarly depressed relative to that of the US.
Why are German Equities So Much Cheaper?
We can say at the outset that the reason has nothing to do with any opportunity cost relative to risk-free bonds. Long-term German bund interest rates are significantly lower than long-term US treasury interest rates, more than 100 bps for the 10 year, which reflects the uncontroversial fact that the future paths of short-term central bank rates in each country are likely to be meaningfully different.
An obvious reason for the difference in valuation is the effect of the Eurozone crisis. Given the anti-growth fiscal, banking, and monetary straightjacket imposed by the currency union, as well as the likely possibility of eventual exits, risk appetite is significantly subdued in Germany, and fear of tail events significantly elevated, relative to the US.
But there’s another interesting difference: demographics. The point isn’t often discussed, but Germany’s population, and Europe’s in general, has an age distribution that is older than that of the US. Aging populations are bearish for equity valuations because older people tend to allocate their wealth with a preference for low-volatility, low-risk assets (such as savings accounts and short-term bonds) over high-volatility, high-risk assets (such as equities).
The following charts show the 2015 population pyramids for the USA, Germany, and Japan:
As we see from the charts, Germany’s demographics, both in terms of population growth and age distribution, look much more like Japan than the US. Of course, equities are traded internationally, and so non-German investors could relieve downward demographic pressure on German markets by buying up “cheap” German equities. But investors tend to display home bias when they invest. Absent a compelling reason to shop elsewhere, they tend to want to stay within their borders. Therefore, we should expect differences in country age distributions to maintain an effect on country valuations, even though there is international access to capital markets.
I think that the differences in the economic, financial and business conditions in Germany and the US–and, crucially, their carryover effects on investor sentiment and appetite for risk–have had a significantly more powerful effect on valuations than simple demographic differences, the impacts of which, in my opinion, are exaggerated. Granted, it is true that if given a choice as to how to meet their income needs, older investors will lean towards cash and short-term bonds, which have minimal credit and interest-rate risk, rather than the more volatile options of equities and long-term bonds. But older investors in the US and Europe aren’t currently being given such a choice, and won’t be given one for a very long time. If they want any income at all in the present environment, they have to take on either market risk, credit risk, or interest rate risk (note that in 2013, this latter risk has been the most costly of the three, and could continue to be the most costly over the next few years).
In the current world of zero interest rates, older investors have proven that they are willing to own equities, provided that they feel comfortable with the health of the economy and the market, and do not see painful losses on the horizon. Ultimately, fears of losses are what keep all of us away from equities, when we stay away. If the possibility of losses, especially deep losses–crashes–could be entirely removed, we would all invest 100% in equities, since, when purchased at normal valuations, they offer much stronger long-term returns than their alternatives.
The difference between older investors and middle-aged investors is that older investors are more sensitive to the risk of near-term loss, given their liquidity needs and time horizons (getting your money back in the eventual recovery is worthless if you won’t live long enough to see it). But this is not to say that middle-aged investors are willing to jump into equity markets that they think are dangerous, or that older investors can’t become perfectly comfortable investing in equity markets that they think are healthy and strong. With any investor, of any age, the key question that determines the investor’s willingness to take on equity exposure is: how do you think equities will perform going forward? Every other consideration is minor compared to that one.
In the course of the cycle, as economies and markets recover from whatever their last negative event was, and as the memories of losses associated with that event abate, older investors, like all investors, become more willing to take on equity exposure. As they accumulate positive experiences in the markets, they grow more comfortable, more confident that their wealth is being invested in the right place. There is no reason why they can’t end up in a situation where they are willing–indeed eager–to be invested in equities.
We have to remember that the current generation of wealthy retirees in the US and Europe (who hold the vast majority of each regions’ investment firepower) made their fortunes over the last 30 years precisely by being invested in the stock market. If you take out the shock of 2008, which is now more than recovered, they are likely to feel a certain amount of goodwill towards the asset class–at least enough to give it a chance, when the only alternative is to sit on the sidelines without any retirement income and watch everyone else make money.