Back to the future Part 3

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Here we go as threatened / promised is part 3 of this film themed set of posts looking at what we can learn about the future for investing by looking at the past. Since the third Back to the Future film was set in the Wild West this post appropriately will take a look at markets which some categorize as the Wild West given their volatility and propensity for crises.

Since sequels often rehash what has gone before lets start by recapping the first two parts. in the first part we saw that real returns from UK equities have been in the region of 5 to 6% in the last 50 to 115 years. We also explored the fact that we have been in a secular bear market since 1999 as the market was on an extended valuation at that time. This highlighted the importance of the valuation levels in determining future returns. We then went on to look at current valuations in the UK market based on dividend yield data from Capita Asset Services. This suggested, that based on current levels of dividend distributions from UK companies, that in the long term future from here, we might be able to look forward to real returns from UK equities roughly in line with the 5 - 6% long term averages, which is nice.

In the second part I left you in the hands of Professor Hans Rosling to talk about demographics and its effects on countries and their prosperity etc. If you have not had time to watch it (spoiler alert) the summary is that the worlds population will continue to grow before levelling out. Most of the remaining growth is going to come in Africa and the Far East and there are good reasons to believe that many in these regions will continue their journey out of poverty towards greater prosperity as their populations grow and their economies become more developed. 

Essentially the demographic trends seem to be pointing us towards emerging markets, although this is not a new idea although it has been found that investing in the highest growing economies has not always been a recipe for success. See the Global Year Book 2014 which had articles on Emerging markets v developed markets starting on page 5, and high v low growth economies and counter intuitive future investment returns on page 17. So in this third part I thought I would look to the future and see if it might be worth looking to play those demographic trends in emerging markets and maybe other developed markets by examining current valuations of global equities.

With the growth caveat in mind lets think a bit about the history. Emerging markets as an asset class really started to develop and become more mainstream in the late 1980's and early 1990's as far as I remember. However, I guess some pioneering investors, such as the late great Sir John Templeton, were early emerging market investors with their investments in the likes of Japan and Hong Kong before these became mainstream. Indeed in the Global Year Book 2014 which I mentioned above, the professors travelled further back in time to 1900 by defining emerging or developing nations based on GDP per capita being less than $25,000 rather than index provider definitions. This suggested that developing markets, on this definition, had produced annual returns of 7,4% and had underperformed developed markets which had produced 8.3% per annum since 1900.




















These returns were however, hit somewhat (classic English under statement there) by the the 1917 Russian revolution when investors lost everything and a post war collapse in Japan when investors effectively lost 98% in dollar terms! In addition another contributor was China, where markets were closed in 1949 following the communist victory, and where investors in Chinese equities effectively also lost everything. However the authors do point out that from 1950, emerging markets staged a long fight back, albeit with periodic setbacks. From 1950 to 2013, they achieved an annualized return
of 12.5% versus 10.8% from developed markets.

In their current guise what today are known as emerging market according to index providers are often referred to as the BRIC's (Brazil, Russia, China, India) a phrase coined by Goldman Sachs, plus many other Far Eastern and frontier African markets which have been though several rounds of enthusiasm and pessimism and associated booms and busts. Their strongest period of outperformance came in the decade after the developed markets peaked in 1999/2000 after the dot com bubble and as enthusiasm for growth in emerging markets really took hold. They have however, in the last five years or so,  underperformed badly with the MSCI Emerging Markets ETF being down by around 15% versus a rise of 85% for US equities & +15% or so from EAFE equities (developed ex US) over the same period, see chart below. After that I provide some graphics looking at valuations on Global markets and I will discuss the implications of these after these which are:
excellent Asset Allocation resources provided by Research Affiliates. The graphics look at :(1) Shiller PE's on global equities, (2) Expected 10 year risk and returns across different asset classes and (3) Expected 10 year risk & returns for individual equity markets.

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At certain times in the past investors have been prepared to pay a premium for emerging markets and then been  disappointed by returns as the natural volatility of these economies and markets kicked in. In fact the important point to remember when investing in emerging markets is that they tend to be much more volatile than developed markets so you need to be prepared to accept that if you are going to invest in them. At other times in the past investors have become very pessimistic about emerging markets after various crises in the Far East and Russia and may be even after the current China crisis if that's what it is. Returns have then tended to be better because, as we learned in part one, future returns obviously tend to driven by the price or valuation you pay at the outset.

It's noticeable that Emerging markets overall and Brazil, China and India are all close to their lows in terms of their Shiller 10 year PE. Meanwhile US equities & Japanese equities look relatively expensive on 25x and 24x while UK and EAFE look more reasonable on 11x & 14x respectively. While CAPE is not necessarily a good short term timing indicator, it does suggest a bias away from US equities and towards other developed and Emerging markets could be good for future returns on your portfolio as per the Real 10 year expected return chart above.






















In passing before I get on to the summary and conclusion it is encouraging / reassuring to see that they also suggest 6% real returns from UK equities over the 10 years confirming what we saw from looking at the Capita dividend based calculation in part 1.

Summary & Conclusion
So far in this series we have seen from studying the past that the price you pay is important for you potential future returns. While a talk on demographics suggests that emerging markets might be a fruitful hunting ground for future growth and increased prosperity, although we also touch on in this part the evidence that rapid GDP growth does not always necessarily lead to above average investment returns, so that is worth bearing in mind too.

However, despite that caveat, the demographics and a look at current valuations suggests that there may some potential from decent future returns from some developed markets and emerging markets going forward in time from here. It is however important to remember that emerging markets are likely to be more volatile than developed markets so you have to be comfortable with that if you are going to consider investing in them.

With that in mind I think I'll go one better than the makers of the original Film series and come back in the future with a part 4 and have a look at ways you can play these areas via London listed vehicles and investment trusts. Still I guess you can never rule out another Back to the Future film because the fashion in Hollywood these days seem to be to re-boot or resurrect old tired franchises - evidence for the prosecution - Jurassic World, Mad Max Fury Road, Terminator Genisis, Star Wars whatever - you get the picture, The End.

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