An Equity Outlook: Are Stocks the Biggest Real Asset Out There?

Executive Summary

• It would be easy to be bearish on today’s strategic equity outlook, given the current environment. But in this note, we’ll outline a case for positive real strategic returns, though perhaps less exciting in historical terms. Note that this note is firmly focused on the strategic multi-year outlook not shorter-term tactical positioning.
• Strong investor flows into public equities and returns in recent years have pushed the US household equity allocation above its 70-year range, but this may be rational, given TINA (there is no alternative): the lack of sufficient alternatives to achieve positive real return.
• We review the evidence that equities count as a real asset and hence are a key anchor for investor allocations when inflation is at a moderately higher equilibrium level.
• Parts of a value trade are an important part of an equity position in a world of higher inflation, albeit with some alterations to what constitutes a value basket if real yields remain low. A basket of sustainable growth stocks is trading at an 11% premium to the market with higher long-term growth forecasts, which doesn’t seem like a challenging level. If they can sustain growth, they should also be part of a strategic equity allocation in a world of low real yields.
• For the valuation skeptics, a closer look at a range of valuation metrics in light of inflation, real yields and investors’ possible need to buy more equities reveals that stocks aren’t necessarily doomed to entrenched negative returns.
• Populist pressures on margins and the corporate profit share of GDP could put downward pressure on earnings growth, but in our view shouldn’t be pronounced enough to make investors bearish.
• We see a compelling case to add strategic exposure to emerging-market (EM) equities, given that they’ve tended to outperform when inflation expectations are rising but not real yields.
• There’s a crucial role for equities as a source of alpha. Correlations within the equity market have fallen, creating more “potential energy” for active outperformance. Historically, active managers tend to outperform as correlations fall.

Introduction

It would be all too easy to write a bearish note on today’s strategic equity outlook:

• Valuations at the top end of a 100-year range
• US$1 trillion inflow over the past 12 months
• Rapid hardening of central bank resolve on inflation
• US household equity allocation above the top of its 70-year range and above 50% for the first time
• Forecasts for corporate margins already at record peaks
• Heightened risks of stagflation given the current Russia-Ukraine conflict

One could use the historical record for each of these observations to conclude that forward returns on global and US equities should be negative. However, this note doesn’t take such a path. These observations may sound gently devastating, but only when viewed in a somewhat myopic light of mean reversion to past equilibria. In this note, we’ll outline a case for a positive real strategic return from equities, though perhaps less exciting in historical terms.

Investors do face stark choices: recent returns have been robust, but the prospect of lower returns ahead will force a rethinking of portfolios. Asset owners must view the equity outlook in the context of overall portfolios. Low yields across asset classes and potentially higher equilibrium inflation leave investors facing the prospect of lower real returns, with Sharpe ratios pressured from both sides.

Given this backdrop, the prospect of a positive real return (though lower than history) makes equities a core portfolio anchor for any investor seeking to beat inflation, whether it’s a DC pension, endowment, sovereign wealth fund or family office. The only exceptions are investors with tighter regulatory constraints or a benchmark not tied to inflation—such as insurance companies.

Investors have several choices, which we’ve set out in recent notes. They can move further into illiquid assets (Private Assets and the Future of Asset Allocation), take on more factor risk (Asset Classes and Factors: What's the Difference?), boost leverage or increase alpha exposure. Many investors will find the need to take several of these routes. But for all investors who need positive real returns, it would be hard to avoid making equities a core allocation, given their scale and liquidity. No other asset with a reasonable prospect of delivering positive real returns can do this.

Inflation is a key consideration, as it is in nearly any macro discussion these days. There’s a good case that exposure to public equities should form a core part of protecting portfolios against moderate levels of inflation. However, this very much depends on the level of inflation and what investors really mean when they say they want to “protect” a portfolio against inflation.

There tends to be an inverse U-shaped relationship between equity valuations and inflation. Outright deflation and high inflation are horrible for equities, implying high risk premia and de-rating. But for higher-but-moderate inflation that we think is most likely over the medium term, equities can likely maintain high multiples. And for investors focused on long-run generation of positive real returns (versus short-term inflation hedging), equities are highly effective.

There are strategic risks, of course. We will show that valuations are very extended based on metrics that have mattered in the past. The market is also more concentrated, hence more dependent on a few very large companies. As we extend the horizon out over multiple years, there will likely be a recession at some point. Despite the recent shift in interest-rate expectations, central banks around the world seem unlikely to be in a position to cut rates to cushion declining growth.

So, investors should prepare for a higher-amplitude business cycle, which implies higher risk premia. We think that more active fiscal policy can counter this scenario (that genie is out of the bottle). However, because that lever is more politically driven, it’s inherently less predictable. There will be no MMT-style automatic fiscal stabilizers in major economies any time soon (though we do see universal basic income in the cards one day). That said, there’s a case for real yields remaining low across the forecasting horizon; ultimately, low real yields and moderately higher inflation can support equity multiples.

This note is strategic—focused on the next five to 10 years—but the near-term outlook can never be ignored. The Russia-Ukraine conflict significantly increases the risk of an extra source of inflation in what was already an inflationary scenario. Moreover, there is a likelihood that this inflation is sustained. With this the risk of a stagflationary outcome is higher than before the conflict, but is by no means our central case. In addition, the planned draining of macro liquidity in coming months stands as a clear hazard to risk assets. Central bank liquidity was central to market support over the past two years; its removal isn’t necessarily bearish, but liquidity can suddenly matter in some environments, so investors need to factor it into tactical risks.

We examine the forces at work on the equity market in the upcoming sections, but Display 1 summarizes the main points.

Valuation is a key headwind: nearly all metrics show equities to be expensive compared with history, but the potential for real yields to remain historically low lessens this headwind’s intensity. Sentiment is often a contrarian indicator, and a US$1 trillion inflow to equity funds over the past year might ring alarm bells. However, we’ll make the case that for many investors, there is no alternative (the TINA dilemma).

Corporate fundamentals have never been better in terms of profitability—is that a sign of permanently better conditions, given the policy backdrop and market composition (efficient mega-caps), or does it signal a pending retrenchment? Finally, equities are a claim on real economic growth, which faces strategic downward pressure from demographics: To what extent can investment in the energy transition compensate for this?

At the end of this note, we’ll bring these topics together to enumerate the return drivers for equities and show how all of this leads to a positive real return outlook.

Buoyant Sentiment: Bear or Bull Argument?

Our broader measure of equity flow, the total purchases of overseas equities by investors in each region (Display 3) has abated somewhat implying medium-term positive returns. 

The state of the two previous displays, combined with strong returns, has pushed US households’ equity allocation past the top of its 70-year range (Display 4). It has also topped 50% for the first time.

One could use the historical relationship between this metric and forward returns to build a bearish case for equities. However, we think this is a good example of where history might not be a guide. In a world of moderately higher inflation, low real yields and the prospect of negative real bond returns, we would argue that the allocation should be above its 70-year range. There aren’t enough private assets for households to buy to make them a realistic alternative.

To put the current equity allocation in the macroeconomic context, we modeled the returns of a portfolio of public equity, private equity, US 10-year Treasuries and global investment-grade bonds using our medium-term return forecasts. The current US household 50% allocation to public equities, if augmented with another 10% in private equity (a generous assumption), 10% in corporate bonds and the rest in US Treasuries, implies a 5% nominal return. To achieve a 6% nominal return while keeping the private equity and global bond allocation constant, the equity allocation would have to rise to 70%. A 7% nominal return target, currently embedded in US pension fund assumptions, would require a public equity allocation of nearly 100%. 

Are There Enough Value Stocks to Support the Market?

The precipitous pullback in growth stocks during the first quarter of 2022 raises questions about the composition of any possible market gains from here. The distribution of returns, valuation and profitability of the equity market is in some ways quite unlike the past: Does this render historical comparisons of market aggregates misleading? This question is relevant globally but especially so in the US, which has been so dominated by a small number of mega-caps with similar exposures, it’s an open question whether the market will rally without them leading.

There are a few critical links between the macro setup and the distributions of both market valuations and returns. Obviously, there’s the corporate sector being dominated by a few mega-cap companies—a structure that seems set to last until deemed politically unacceptable. Also, low real yields amplify this valuation spread by increasing the net present value of distant cash flows to a level never seen before.

Finally, there’s inflation. The long-run (and hotly debated) links between inflation and value-factor returns have been hard to disentangle from other forces at work. Structural and cyclical forces are at work. Structurally, the way technological innovation has displaced whole industries and also the shift of corporate investment from tangible to intangible assets raise questions about measuring value. Yet we can also show persistent linkages between inflation and the performance of the value factor that could be cyclical. How much of value’s underperformance in recent years has been structural versus cyclical?

The mega-cap valuation has fallen back into the range of the rest of the (cap-weighted) market, but profitability remains a gap. We discuss later how profitability is set to slow over strategic horizons; current margins depend massively on whether one is buying the market passively at index weights or looking at the “average” company. Both are at cyclical highs (Displays 5 and 6), but the levels differ: the US cap-weighted net interest margin is 11.2%, while the equal-weighted one is 8.8%. When one buys the US market passively, it’s on a cap-weighted basis…is that extended level sustainable?

Mounting wage pressures will likely affect these margin numbers, and we’re also seeing ongoing support for high margins and high profitability from a) investment in automation over the course of the pandemic and b) aggregate profitability of the corporate sector, which is likely to remain elevated in the near term thanks to the presence of mega-cap names, which are more profitable than the average firm.

For over a decade, the dispersion of valuations has been wider than was historically the norm in global and US equity markets. Dispersions then became even wider during the pandemic, but the increase in real yields in 1Q:2022 has tempered this somewhat.

Viewed on an unweighted basis (Display 7), the spread of US and global valuations has seen the recent increase in real yields remove some of the most extreme parts of the distribution, leaving us with a pre-pandemic valuation dispersion. So, mega-caps per se are not an issue; instead, the key question on the distribution of equity returns is the prognosis for real yields and inflation. 

In response, investors wishing to think beyond aggregate equity exposure should consider explicitly taking two different kinds of exposure as a strategic allocation: a world in which real yields remain low implies a position in select growth companies, while the prospect that inflation is finding a higher equilibrium position implies a position in value. 

Is Growth Stock Exposure Simply a Rates Trade?

Surely, no one can still doubt that exposure to growth stocks is a macro bet. That notion has been emphatically supported by declining yields in recent years. Market forecasters have forecast rising yields for years without much success. But there’s a strong case now that yields will rise, not fall.

Will this doom the growth trade? And if it does, how can one justify a positive view on US equities when 29% of the market is tech alone? It’s important to bear in mind that long-duration equities aren’t the same as long-duration bonds. They’re able to grow, potentially in positive real terms, since they represent claims on cash flows in the real economy.

That’s why we think it’s crucial to distinguish between growth stock returns when real yields are rising versus when inflation is rising. Yes, there’s been a recent focus on an upward shift in real yields, with the Fed indicating a stronger inflation response than investors thought three months ago. But in the greater scheme of things, the main upward move in bond yields is inflation breakevens, not real yields. This implies that there IS indeed a role for long-duration equities—the key question isn’t really justifying the valuations but justifying the belief that they can sustain their ability to deliver real growth.

We see a case to be made that real yields will stay low, despite all the brouhaha of the Fed’s pivot. In part, this view stems from the deflationary forces alongside forces that are inflationary today (the need for the savings rate to rise and the ongoing force of automation) (Assessing the Inflation Trajectory—and Portfolio Responses). Also, to the extent that real yields are a measure of future growth, the decline in the global (ex Africa) working-age population locked in by current demographic trends implies lower growth, unless one is willing to claim a historic change in productivity.

The corollary of low real yields is that a disproportionally large part of the net present value for many companies will still be far off into the future. Thus, the key point on the average growth stock is not trying to justify valuation, it’s to focus analysis on whether one can believe in that growth being sustained. The recent abrupt divergence in returns between Amazon and Meta Platforms, both registering as record daily shifts in market cap, is a case in point.

In Display 8, below, we show the valuation of our sustainable growth screen—a broad selection of US growth stocks that attempts to test for growth sustainability and justification of valuation. We remove stocks with price/earnings-to-long-term-growth (PEG) ratios above 3x as well as those with earnings growth forecasts that seem disproportionate versus history. Specifically, we omit firms whose consensus three-year-forward earnings-per-share growth is more than 10 percentage points above their 10-year trailing growth.

Currently, the sustainable-growth factor trades at an 11% premium to the overall market (Display 8) with a consensus long-term earnings growth forecast of 18.5% versus the overall market’s 17%. This doesn’t seem like a challenging level. Thus, if these companies can sustain their growth rate, they should be an important strategic part of an equity allocation in a world where real yields remain low. Note that this basket includes some of the mega-cap growth names that we discussed earlier. 

Alongside the allocation to sustainable growth companies, the prospect of higher but still moderate inflation implies an allocation to value too. We discussed this in more detail in Inflation and the Shape of Portfolios. As we made clear then, inflation is in no way a panacea for value stocks, because structural headwinds remain. Moreover, as we’ve discussed elsewhere, if inflation rises without a commensurate rise in interest rates, then the kind of value exposure one wants may require a reduced weight on financials.

Valuation…and Its Discontents

Any positive view on equities must overcome the valuation hurdle. There will inevitably be skepticism about valuation metrics’ ability to give a signal: using these measures in isolation would have called for reducing equity allocations ahead of the large market run-up both before and after the pandemic’s onset. However, there’s evidence over long periods of history that these metrics have a role to play. In this section, we analyze the efficacy of valuation metrics and review their current signals.

In Display 9, we show the efficacy of a range of valuation metrics in predicting forward returns. All of them become more effective as the forecasting horizon is extended out, which is normal for any kind of valuation metric. In terms of effectiveness, price/national accounts book value is the most reliable, but it’s only available quarterly, doesn’t go further back than the 1950s, and has no comparable equivalent across regions and market segments. The Shiller P/E ratio described earlier ranks second in efficacy, but is available monthly with a much longer history and easier comparability across regions. 

The Shiller P/E (price divided by inflation-adjusted 10-year average earnings) has often been our starting point for long-horizon equity return forecasting. Over short horizons, it doesn’t tell much about returns. However, it’s one of the most effective measures over 10-year horizons—especially given the ease of getting the data to make comparisons internationally and across market segments. The 140-year relationship between the Shiller P/E and 10-year forward returns (Display 10), taken at face value, implies an annualized total return of –1% annualized for US equities over the next decade. And that’s in nominal terms, to boot.

Price to national accounts book value tends to be used less often, but it has actually been effective historically. The indicator shows a more extreme market valuation and is currently at an all-time high (Display 11).

The other two popular valuation metrics are the Buffet indicator (market capitalization divided by GDP) and Tobin’s Q, a company’s market value divided by its assets' replacement cost. As we show in Displays 12 and 13, both are at historic highs as well. The elevated market cap/GDP illustrates a broader macro point that financial assets have strongly outpaced real assets in recent decades, but there’s a question as to whether this can continue (Portfolio Strategy: Oops—I Hit My 10 Year Price Target with 8½ Years to Go…What Do I Do Now?). 

When we overlay Tobin’s Q with the Shiller P/E, we think it’s an important point that these two metrics give similar conclusions—even though one shows equity multiples relative to a stock’s replacement value while the other shows them relative to a “flow” of earnings. They arrive at this similar conclusion via very different routes.

These readings don’t necessarily doom equities to entrenched negative returns for a combination of several reasons: the inflation prognosis, real yields and investors’ possible need to buy more equities as a result, a point we make elsewhere in this note.

The Shiller equity risk premium valuation metric is one metric that’s not extreme. It compares the earnings yield from the Shiller P/E against the inflation-adjusted US 10-year government bond yield, and currently forecasts a 3% premium over bonds. This would bring the overall real return for US equities to around 4.8%, or 6.8% in nominal terms, assuming 2% annualized inflation (Display 14).  

Could Populist Pressures Threaten Corporations’ Peak Profit Shares of GDP?

Corporate fundamentals have never been stronger, even when leaving aside the shifting market composition, with the presence of efficient mega-caps boosting aggregate profitability. Pre-tax margins have been high, with a generous tax environment making post-tax margins even higher historically. The shift in the balance of labor-capital bargaining power in recent decades means that the profit share of GDP is at a peak. Can this be maintained, or are corporates doomed to a tougher regime?

Also, buybacks have been key contributors to the cash return to shareholders, but are their days numbered? In the decade before the pandemic, corporations emerged as by far the strongest source of demand for US equity buying, and in Europe and Japan as well. But there’s a case to be made that buybacks disproportionately benefit the richer owners of equities, contributing to inequality. This could put them under pressure in years ahead.

We do see downward pressures on both margins and the corporate profit share of GDP (Display 15). In the short term, an upward wage shift at least makes it harder for recent margin gains to be maintained; longer term, we see pressure to reduce the corporate profit share of GDP in favor of labor. This may happen faster in Europe than in the US, a dynamic that could play out over several election cycles. 

However, a peak in profit share of GDP hasn’t been a negative signal for US stocks historically. In similar episodes since 1950, US equity returns (on average) have been positive across horizons from three months to two years. The only time US stocks were negative in the following 12 months was 1973 (Display 16). But the average Shiller P/E at previous profit peaks has been 18.6x, considerably lower than today’s 39.6x. A profitability peak in the face of high multiples could prove more problematic this time.

The bottom line is that this setup could put downward pressure on earnings growth, but not enough to make investors bearish.

EM Equities Benefit from Rising Inflation Expectations

We’ve described our equity view mainly from a US standpoint, which we think is appropriate, given a long-term overweight stance from a regional perspective. But we also see a case to add a strategic exposure to EM equities too.

EM stocks tend to outperform when inflation expectations are rising but not real yields (Display 17), a pattern shown more rigorously in Display 18 through a regression summary. Since 1970, EM outperformance is linked positively to a rising US 10-year break-even inflation rate and is hurt by rising US 10-year real yields. But the link to inflation is more statistically significant, and with a higher beta.

Our medium-term base case is for inflation to settle higher than the historical average with real yields remaining low. So, we see a case for adding an EM position alongside US exposure over a strategic horizon of five years. But we would exclude China from the EM exposure, because its current policy-driven environment and its impact on equities create highly idiosyncratic risks. We also believe that China exposure should be viewed distinctly from broader EM and analyzed separately.

From a valuation vantage point, EM valuations don’t seem excessive. Based on its cyclically adjusted P/E ratio, EM is trading at a 46% premium, and 51% excluding China (Display 19). However, EM’s 23x CAPE multiple is considerably below the 39.6x for the US and a long way away from its previous peaks in 1997 and 2007.

Is Equity an Inflation Hedge…or Truly a Real Asset?

A core part of our view is that equities are a portfolio anchor for investors needing positive real returns, given the moderate inflation we’re expecting. What’s the basis for our claim? We like to point out that, in many senses, equities count as a real asset. However, discussions with clients and colleagues reveal that this view is far from universal.

There are two ways to argue that equities are a real asset: One can follow in the footsteps of Roger Bacon and lay out the empirical evidence of equity returns in inflationary environments. Or, the theoretical and normative approach argues that equities represent a claim on cash flows determined in the real economy, so they must be real assets.

The role of equities in insuring portfolios against inflation depends very much on time horizon. We made the case in previous research (Assessing the Inflation Trajectory—and Portfolio Responses) that the meaning of an inflation hedge is tied to time horizon. For investors with a long horizon (such as investors earlier in a target-date glide path), an inflation “hedge” probably translates into assets that can continue delivering positive real returns in higher-inflation environments.

By contrast, an investor with a shorter horizon or tighter risk controls might find an inflation hedge in an asset that generally tracks inflation regardless of its long-term real return. In the short term, equities may at times be ineffective hedges if upward inflation shocks hurt their returns, either through an expected rise in risk-free rates (e.g., a change of policy) or an increase in the risk premium (given a risk of truly high inflation rates). Our case for equities as an inflation hedge is very much aimed at rising risk-free rates; we discussed options during rising risk premiums in our prior inflation work.

Let’s start with the empirical data, since it’s less controversial. In Display 20, we show the average annualized performance of the aggregate equity market, individual sectors and equity factors in different inflation regimes defined by inflation bands ranging from less than 1% to more than 5%. In the 2%–4% inflation range, equity indices can deliver strongly positive real returns. From a long/short factor perspective, higher inflation (3%–4%) is positive for momentum, quality and low volatility. At the sector level, technology, real estate and industrials tend to outperform when inflation is in the 2%–4% range. 

We also show in Display 21 the relative return/risk trade-off for US sectors when inflation is in a 2%–4% range. A range of sectors tend to help portfolios: those directly tied to real assets, such as real estate and energy; sectors that can deliver positive real growth (healthcare, tech); and those that offer lower-volatility income but with a link to inflation (utilities).

An inverse U-shaped relationship exists between equity valuation and inflation (Display 22). The common central bank inflation target of 2% is, lo and behold, the level that tends to maximize equity valuations. The risk premium tends to increase, so valuations decrease, at higher and lower inflation levels.

Low inflation raises the risk of outright disinflation, pointing to a lack of growth. Very high inflation destroys the visibility of far-distant earnings and raises the prospect of higher interest rates. Inflation in the 2%–4% range is still consistent with high multiples, so a moderate inflation outlook doesn’t necessarily require a downward mean reversion in multiples.

Such is the empirical evidence for returns and valuations in response to inflation. But is there evidence from equity “fundamentals” demonstrating that they are indeed claims on cash flows in the real economy? The last 12 months have seen higher inflation along with high profits: How normal is that?

Let’s start with the link between margins and inflation, measured both by CPI and 10-year breakevens (Display 23). It isn’t perfect but, on balance, margins have been able to rise even when inflation rises. That’s not to say margins can’t suffer tactically over the next one to two years as labor costs rise, but in aggregate, the corporate sector has managed to raise prices with inflation in a way that, over the cycle, can offset costs.

From an earnings lens, real earnings growth can also remain positive even in higher-inflation regimes (Display 24), based on year-over-year growth in real profits overlaid with inflation. We define real profits here as nominal earnings growth for S&P companies minus CPI. Because earnings growth is often flattered by buybacks, we remove that effect and use the growth in total nominal dollar earnings. As the evidence suggests, even higher inflation doesn’t preclude positive real earnings growth.

Since 1965, the geometric average real growth of total earnings has been 4.0% annualized. There’s a sweet spot when inflation ranges from 2% to 4% and real growth in total earnings has averaged 8.5% annualized (Display 25). However, even in periods when inflation was above 4%, real earnings growth was 4% annualized. The worst periods were during low-inflation regimes, when real profit growth was less than 1% annualized. Thus, there’s a non-linear relationship between inflation and real profit growth, but skewed in favor of higher inflation. 

We think this analysis points to a fundamental and empirical case for equities to be regarded as real assets, though there seem to be long-run “regimes” for the real-growth ability of the corporate sector. It grew real earnings from 1965 to 1980 and again from 1992 to 2022. However, from 1980 to 1992, real profit growth was only achieved within each cycle and then lost, with no net real growth over that period.

The Case for Alpha Generation in Equity Markets

This note mainly addresses equity exposure from a beta perspective and its portfolio role in the current environment. However, there’s also a crucial role for equities as a source of alpha—an argument with two strands.

First, in a world where beta returns are expected to be lower, if anyone can demonstrate skill at generating persistent alpha, then it mechanically means that returns from alpha will be a larger part of end-investor total returns.

Occasionally, investors don’t believe in alpha. We’ll leave the philosophical angle of it to another note. We will, however, simply note the grey area between alpha and beta that’s also dynamic. Our Alphalytics work has highlighted robust ways to better identify strategies with the ability to deliver persistent, idiosyncratic alpha over and above simple semi-passive factor strategies (Alpha, Beta and Inflation: An Outlook for Asset Owners).

The second strand in the equity alpha argument is the availability of alpha in the market. Correlations within the equity market have fallen (Display 26), both the average pairwise correlation between stocks and the correlation between factors. This can be thought of as the “potential energy” that allows for outperformance of active managers.

Usually, correlations spike when there’s an exogenous macro shock. In these periods, stock performance is driven more by common shocks to the discount rate rather than by the idiosyncratic cash-flow expectations of individual corporations. However, as COVID-19 ultimately recedes further into the past, we expect correlations to fall, which tends to open up the field for alpha generation.

We showed recently that in periods when correlations fall, and over the year following that decline, active managers tend to outperform.[1] We think there’s a good justification for this linkage. Think about it in terms of the so-called “fundamental law of active management” from Richard Grinold, which states the following relationship:

Where IR is the information ratio, IC is the information coefficient or investor skill and n is the number of independent investment opportunities. (It can be argued that other metrics could be added, such as the ability to transfer views into portfolios that come from mandate limitations.) If one assumes, for the purposes of argument, that skill is constant (or at least slowly evolving), then changes in IR are mainly driven by the number of independent investment opportunities. As stocks become less correlated, the number of these independent investment opportunities rises. 

Bringing the Equity Story Together

Bringing the forces at work on equity returns to arrive at a strategic view, we can write:

Real equity return = dividend yield + buyback yield + real growth per capita + population growth + change in profit share of GDP + multiple expansion/contraction

We’re subsuming margin expansion/contraction in the broader measure of the profit share of GDP, as we see the pressures on the two as being related.

Let's assume—for argument’s sake—that multiple and margin stay constant. We’ve already discussed the issue of the high multiple, but this could be maintained through a combination of low real yields and TINA-type arguments by investors that would prompt more equity inflows (we recognize that the inflow argument is somewhat circular). Profit share of GDP has been elevated, and the risks are more to the downside over strategic horizons.

Another way of thinking about this: using real growth per capita as the growth rate assumes that listed equities are a good representation of broader economic growth. Estimating the potential downside risk is beyond the scope of this analysis, but the real return numbers we arrive at below are generous enough to withstand a decline on the order of 1–2 percentage points (a large drop in the context of historical shifts of profit share), which would still leave equities as an anchor for cross-asset portfolios.

This forecast also depends on the prognosis for buybacks and their fungibility with dividends for investors. For the past 10 years, corporations have easily been the biggest equity buyers—far outstripping investors. The environment of the past decade has encouraged firms to lever up balance sheets and issue debt for buybacks.

We see limits to how long this structure can be maintained, as a growing chorus claims that it leads to greater inequality and constitutes a governance failure—in other words, corporate management teams are measured on too short a horizon, which encourages lower capex and more debt issuance to complete buybacks. In our base case, we assume the future will be like the recent past, but pressure to reduce buybacks would likely create a commensurate increase in dividends.

The UN population growth projection for the US is 0.6% per year; the achieved real GDP per capita average growth over the past 30 years has been 1.5% annualized (with long-run consensus forecasts tending to be in a similar range). The US dividend yield is 1.3%, and the 10-year average net buyback yield (buybacks minus issuance as a percentage of market cap) has been 1.7%. If the multiple or profit share are unchanged, the decomposition of returns simplifies to:

Real equity return = dividend yield + buyback yield + real growth per capita + population growth

So, what does this imply for real return? Plugging in numbers to the above equation yields:

Real return = 1.3% + 1.7% + 1.5%+ 0.6% = 5.1%

This return is in real terms; if we tack on assumed inflation at 2% annualized over the forecast horizon, this leaves us with a 7.1% annualized nominal return for US equities. That’s a solid return for equity markets in an environment of modest inflation, that builds in an ability for a decline in margins to moderately eat away at this somewhat.

¹Alla Harmsworth, Harjaspreet Mand and Ravi Verma, “Alphalytics: Active returns in a synchronized world,” Bernstein Research, December 20, 2021.