Deconstructing equity returns: Insights for a new rate cycle

Since the end of 2019, global equities have delivered a total return of over 100%. Given the COVID-driven storm that engulfed the early part of the period, this performance has been remarkable. This feat has been driven by improving fundamentals as well as prices in the form of multiple expansion. With the US Federal Reserve setting the scene for a shift in interest rate policy, we assess what investors should be considering in an evolving market landscape.

Total returns to equity investors are comprised of distributions, in the form of dividends and other cash items, and movements in share prices. The share price is driven by changes in fundamentals, such as earnings, and changes in the multiples that the market is willing to pay for those fundamentals. The price-to-earnings ratio is one of the most common yardsticks for measuring the cheapness or expensiveness of an equity.

By disaggregating total returns into three component drivers: dividends, earnings, and prices, we can gain insight into the factors that propelled equity markets to that c.100% return since 2019. (Figure 1).

Dividends typically are a relatively small component of the overall return, but these tend to be more consistent — companies are loathe to cut dividends due to negative investors reactions. For a universe as broad as the MSCI World Index, earnings also evolve relatively smoothly over time; generally these trend upwards, except in periods of exogenous shocks such as the COVID pandemic. One notable development in recent years has been the increased concentration in strong-performing technology and AI-related companies that has resulted in a narrowing band of stocks being responsible for much of the overall earnings growth in markets in recent years.

Which leaves prices, in the form of multiple expansion and contraction, as typically the most variable element in the total return calculation. Global equity markets are currently significantly more expensive than their long-term average, following a sustained period of multiple expansion since the lows of 2022 (see Figure 2). These relatively expensive valuations leave equity markets vulnerable to a turn in the cycle or a shift in risk preference, and potentially exposed to a rapid snap-back in valuations.

The relationship between earnings, valuation multiples, and interest rates

The multiple that equity investors are willing to apply to earnings varies over time and is driven by macroeconomic, microeconomic, and behavioral factors — including “fear” and “greed” factors. Among the more tangible drivers of markets P/E’s variation over time are interest rates and bond yields, and therefore discount factors used to value equities. As yields fall, the discount rate applied to future earnings reduces supporting higher valuations, all else being equal. While earnings growth has been a robust 23% in the period since the dip in October 2022, the P/E ratio has expanded by another 33%. This suggests that equity markets may have been positioned for the long-expected US interest rate cutting cycle before it even started.

The path of valuation multiples and interest rates is a bit more nuanced than a simple one-to-one relationship, however, and the starting point matters a lot. For many years after the extreme valuations of the tech bubble in the late 1990s, multiples reverted downwards from extremely high levels even as interest rates were lowered. It was not until after the Global Financial Crisis that a more “normal” relationship of valuation multiples expanding as interest rates fell was re-established.

Most recently, as bond yields have kept climbing, valuation multiples have continued to expand to levels close to the COVID peak, although they’re still some way off the highs of the tech bubble. The currently extended valuation starting point, and past history, suggest we should not extrapolate too far the relationship between falling yields and seemingly ever-increasing equity valuations.

The importance of resilient equity investment processes

The path of valuation multiples, earnings and bond yields is not a simple one to forecast. Building an investment process around predicting any one of these elements is a very low-breadth decision and potentially leaves investors open to extreme outcomes.

We believe a better way of designing an investment process is to build it for the long term. We’re not betting on a narrow band of outcomes, but looking to construct a process that is robust through an extended period, and through different cycles. We build our stock return forecasts around fundamentals such as valuation, earnings, and quality measures. But we also use state-of-the-art tools and techniques to measure sentiment and catalysts within markets — for example, to build a rich and nuanced view of expected returns.

We cannot know what the next few months will bring from a macroeconomic, political, or geopolitics perspective, but we believe our embrace of diversification within our investment process, that is not dependent on a single path through time, will be beneficial through the cycle ahead.

To learn more about the views and investment capabilities of the Systematic Equity – Active team, please visit our website.