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Jacob Miller breaks down three key drivers of past equity returns—and why they may not repeat
Key Takeaways
- Over the past 40 years US equity outperformance largely has been driven by three major tailwinds: falling interest rates, globalization, and a shift to higher-margin sectors.
- Each of these forces now appears to be peaking or reversing, suggesting they are unlikely to provide the same level of support to markets going forward.
- Stripping out the effects of rate declines, global sales growth, and margin expansion paints a far less compelling picture of long-term equity performance.
When we look back at the last 40 years, a lot has changed. But three big forces stand out in terms of driving markets. One is falling interest rates from inflationary peaks in the late ‘70s and early ’80s. We've had a secular decline in both the long rate and the short rate, with ups and downs along the way, but the trend has been supportive to assets. Globalization—a massive increase in trade, import penetration, and outsourcing—supporting both revenues with foreign sales and costs with cheaper inputs and cheaper labor. And a sector composition shift, going from a more, you know, hard manufacturing-based economy with high cost of inputs to a technology and sector-based economy with higher margins.
And those have driven the exceptionalism and outperformance in U.S. equity markets over the last 40 years, but look unlikely to repeat themselves, with globalization at or near peak and seemingly reversing, interest rates near lows and so unable to provide the same lift, and with a sector shift that already seems basically complete. Maybe we'll get a small continuation, but unlikely to be the massive support that it's been on a backward-looking basis.
Why have these three forces been so important to the equity and risk asset market performance? Think about how equities create value. You have dividends, which are low and relatively stable, and then change in price, which is most of the change that's going to be driven by the change in earnings per share and the change in multiples. On the earnings side, you both have a lift to top-line growth from foreign sales, which are now 41% of all sales in the S&P 500 and growing much faster than domestic sales. And on the margin side, a decrease to debt service from a decrease in interest rates and a decrease in cost of goods sold and input costs from offshoring. Also on the margin side, the sector shift has been important as the economy’s moved from lower-margin sectors to higher-margin sectors. That's boosted the overall index.
On the multiple side, the decrease in interest rates lifts all assets. You discount all future cash flows by a lower rate, and so just from that, you got a PE expansion because of a lower discounting rate. Lower borrowing costs have also spurred borrowing and spending via mortgages, via consumer debt, via corporate borrowing, which has also been supportive.
If we try and isolate these drivers, looking at the U.S. equity index, removing financials and trying to strip out the change in margins from globalization and interest rates, and the change in sales from removing an increase in foreign revenue, we get a very different equity picture over the last 40 years. About half of the performance driven by those three forces, and a much less interesting experience for risk asset investors over that time period.
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