The stock market's rise from the depths of the financial crisis has been nothing short of spectacular. Those returns, however, are largely owed to the actions of central banks.
As the influence of quantitative easing diminishes, the realities of economic frailty and ballooning debt relative to gross domestic product will again come into focus, having a profound effect on all asset classes. With equities, the drivers of returns will change, benefiting a more select group of stocks. This will require institutional investors to think differently about their equity allocations.
It's not news to anyone that unconventional monetary policy has reflated asset prices, especially financial assets. But not everyone appreciates the full extent of it. In 2012 and 2013, three-quarters of the gain in the MSCI World index came from the expansion of valuation multiples.
What are the elements that explain this surge in equity asset prices? There were two powerful contributors. The first is the “power of zero.” The stock market is often characterized as a “present value machine.” Its level reflects the perceived stream of cash flows from publicly traded companies worldwide, discounted by a rate that reflects the real rate of interest plus other measures of future uncertainties. When central banks lower that real rate of interest to zero or near zero, the present value of corporate cash flows rises sharply.
The second important element is the “power of the word,” neatly encapsulated in Mario Draghi's now famous statement: “the (European Central Bank) is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” Mr. Draghi, president of the ECB, said, in effect, that central bankers would not allow the monetary system to fail, and that tail risk for equity markets would be kept in check.
But the free ride, courtesy of the world's central banks, is largely over. They have done what they can, and in the case of the Federal Reserve and the Bank of England, they are stepping back from the artificial suppression of interest rates on the long end of the curve. We are beginning to see the effect of that in 2014: Valuation multiples have moved very little so far this year.
Higher interest rates are not the only headwind for valuations. Most of the money printed by the central banks has not found its way in any meaningful fashion into the real economy. The average person has not seen after-tax income rise much at all over the past several years. Developed economies are suffering from weakness in productivity gains and workforce growth, the two key components of GDP growth. Furthermore, a high level of debt relative to GDP among developed economies limits the boost that would normally come from credit growth. With economic growth restrained, valuation multiples will discount slower earnings growth — diminished expectations put a damper on the “P” as well as the “E.”
Equity returns come from only three sources: valuation multiples, earnings and dividends. With multiples no longer able to contribute, that leaves earnings and dividends as the main drivers of returns. And earnings will likely be limited by economic growth that is slower than what we would typically expect in an economic recovery. Fortunately, profit margins should stay higher than historic norms thanks to the deployment of technology and the flexibility of global supply chains.
Paying dividends will continue to be prominent in the capital allocation policies of companies that are disciplined enough to avoid reinvestments and acquisitions that don't earn their cost of capital. Recall, dividends come in three forms — cash, share buybacks and debt pay-downs — collectively known as shareholder yield.
Dividends have been the most consistent driver of equity returns over the long-term history of the stock market. Equity strategies that emphasize dividends likely will continue to gain traction with institutional investors seeking lower volatility from their equity exposure.
The key will be to gain exposure to companies that can grow dividends over time. For many investors, a discussion of dividend-paying stocks brings to mind large “value” stocks that pay dividends because they are in mature markets with no growth opportunities in which to invest their cash flows. This is absolutely the wrong approach. There needs to be an underlying growth rate in cash flows — the source of earnings and dividends — in order to see dividend growth. So the best dividend strategy is really a strategy that identifies companies with the ability to grow free cash flow and allocate it in a disciplined way.
Institutional investors continue to transform their asset allocation framework in an effort to reduce the overall volatility of returns. But aside from the minority that has shifted entirely to liability matching, equities (public and private) will remain the engine of growth, even in a reduced role. Equities capture productivity growth and hedge against inflation — no other asset class does both.
Understanding what will drive equity returns in the coming years should help institutional investors make allocation decisions that will improve their chances of achieving goals for superior risk-adjusted returns.
William Priest is CEO and co-CIO of Epoch Investment Partners Inc.
