UK: Equities In A Slower Growth World

Last Updated: 17 June 2016
Article by Ian Stewart

One of the most frequently quoted pieces of investment advice is that equities are a good long-run investment.

The argument runs that for all the ups and downs of the stock market equities outperform other assets, such as cash or government bonds, in the long term.

Like much investment advice this one comes with caveats, in this case two rather hefty ones.

The first relates to "the long term".  Over the last century UK equities have had some periods of terrible performance, where investors either lost money or would have done better holding other assets. At some times in the last 110 years you would need to hold UK equities for more than ten years to make up for periods of underperformance.

The second caveat is the money-making properties of equities in the long term relate to their performance in the past. There is no certainty that history will repeat itself. In the familiar words of the health warning that accompanies most retail investments, "past performance is not an indicator of future performance".

The annual Equity Gilt Study, sponsored by Barclays, provides an excellent starting point for thinking about these issues. The Study has been published every year since 1956 and is a goldmine of data on the long run performance of UK and US equities.

They confirm that equities have given good returns over the very long term. Over the last 116 years UK equities have returned an average real return after inflation of 5.0%. At this rate of growth the magical power of compounding leads to large gains over time. A 5% annual return increases the value of an initial £100 investment to £163 in 10 years, £265 in 20 years and £1147 after 50 years.

Equities do well when growth is strong, even if, as in late 1970s and early 1980s, it is accompanied by high inflation. Good growth boosts profits and company valuations and many businesses can compensate for high inflation by raising prices. 

Conversely periods of weak growth and low or falling inflation, as was seen in the Great Depression of the late 1920s and early 1930s, are bad news for equities. Between 1928 and 1931, when consumer prices fell 12%, UK equities lost almost half of their value. US equities fell by more than two thirds.

The period that started with the Global Financial Crisis, in 2006, has been a milder version of the Great Depression, marked by sluggish growth and weak inflation. It has been a difficult environment for equities. UK shares have given an average real return of 2.3% in the last 10 years, half that seen in the last 116 years.

The asset that has thrived has been government bonds. These are loans made by the private sector to government and are initially sold yielding a fixed interest rate. If inflation and market interest rates subsequently fall, as they have in the last 10 years, the value of bonds goes up. Bonds have the additional advantage over equities that governments do not go bust. At an extreme a government can print money to repay its debts. In times of uncertainty the guarantee that you will get your money back at the end of the investment term is a highly attractive one. 

In the last year UK government bonds have returned an average of 3.0% a year in real terms compared to a 2.3% real return on equities.

Japan provides a longer run and more extreme example of deflationary conditions hitting equities. Japan's long post war boom came to an end in 1989 with a spectacular collapse in its equity market (you get a sense of the scale of the value destruction from the fact that 27 years later the Japanese equity market is trading at about 40% of its 1989 peak value). From being seen as the economic powerhouse of the global economy, Japan ended up portrayed as an ageing, deflation-prone growth sluggard.

Slow growth and falling prices have been bad news for holders of Japanese equities and great news for those who invested in Japanese government bonds. A back of the envelope calculation suggests that £100 invested in Japanese equities in 1989 would, even with all dividends reinvested, be worth rather less than £100 today. If you'd put the same money into Japanese government bonds you would have an asset worth £250.

Equities did well in over time in the twentieth century against a backdrop of buoyant growth and generally positive inflation. The post-Lehman world of slower, volatile growth accompanied by low or falling inflation has proved much more challenging.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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