Equities are still a good bet

Jul 23 2008 by Andrew Miller for The Journal

UK economic news over the last week has been bad. Consumer prices are now increasing at an annual rate of 3.8%, almost double the Bank of England’s 2% target.

Inflation is now likely to reach almost 5% by the autumn. At the same time, the labour market is being pulled down by the weaker growth outlook. Claimant-count unemployment has now increased by an average of 14,000 over each of the last three months, a rate of job loss similar to that of the US when differences in the size of population are accounted for.

So, all in all, the Bank of England remains stuck ‘between a rock and a hard place’. UK economic growth is slowing sharply – but rising inflationary pressures suggest that the authorities may have to remain on the sidelines, at least until late in the year.

Poor economic news has been accompanied by some distinctly wobbly equities markets around the world. Many of these have moved into what is described as ‘bear market territory’ – a fall of more than 20% from their peak.

For example, at the end of last week, the US’s S&P 500 was down around 15% on a year earlier. As stock markets were also struggling in the previous equities cycle (over 2000-03), the S&P 500 has given a zero return in real (ie inflation- adjusted) terms over the last 10-year period.

And to make things worse, the return here is measured in US dollars, so in many other currencies the real return from the S&P500 has been negative. Weak long-term equities performance prompts the question as to whether one should invest significantly in equities. The answer, we believe, is yes. Equities still look quite attractive for long-term investors (five to 10 years) – even if the short-term outlook is as fragile as ever.

The reasons for our optimism are two-fold. First, we do not expect equities to give a negative long-term return as current valuations are quite low and we see no reason for earnings not to rise in line with macroeconomic growth over the next five to 10 years.

Second, history shows that the long-term performance of equities is strong following major sell-offs. There have only been five periods since 1970 where the rolling one-year total loss of the S&P 500 has been greater than 10%.

And after these periods there have been sustained recoveries. Measured on a cumulative annual growth rate, the nominal returns have averaged 11% for the five-year period after such a fall, and 12.5% for the 10-year period. In real terms, the equivalent numbers are 6.6% and 8.0%.

To look at this another way, the increase in inflation and the risk of recession has already hurt equities’ performance gravely. But it has also set up equities up for a well above average long-run return in both nominal and real terms.

This, of course, assumes that we do not return to a period of sustained high inflation levels. We do not think that this is likely, so we continue to think that equities are a good long-term investment – although some further short-term upsets are certain.

Andrew Miller is regional head Barclays Wealth