Things usually turn out better than we feared

If there is one thing that many of us wish we could change about the past, it’s quite likely that we wish we had worried less about the future. Why is this?

| 4 min read

Over time things have a habit of turning out better than we feared. This is not to suggest that we adopt a Pollyanna mindset, but to simply highlight that there is a tendency to view uncertainty as a negative.

Now, if we turn to the business of investing the whole exercise is fraught with uncertainty, and the word we use to capture and quantify this phenomenon is risk. Anyone holding a portfolio of equities will understand they are effectively owning claims on company cashflows which extend many years into the future and predicting these with any degree of certainty is exceptionally difficult.

How the market values these claims will depend upon the trading prospects for the companies themselves, which in turn will be influenced by the economic outlook. Elsewhere, the valuation of other asset classes such as bonds and property will also be a relevant consideration for investors in shares.

Yet, just as is the case in our daily lives, there is also a tendency on the part of investors to couch uncertainty and risk in negative terms – i.e., what could go wrong and how much money do we stand to lose if our worst fears are realised. Whilst this type of scenario analysis should be part of every investor’s armoury it should not be at the exclusion of looking for potential outcomes that may turn out to be positive.

US Corporate Profits and S&P 500
Source: Bloomberg

The chart above shows the performance of the US equity market and the growth in US corporate profits since World War Two. As the economy grows so do corporate profits and, over the long term, this is reflected in a rising stock market.

This is not to say that equities do not suffer periods of sluggish returns. The 1970s was a case in point. Spiralling energy prices, runaway inflation and double-digit interest rates were strong headwinds for equities during that period. However, even during that time the S&P 500 (including dividends) returned mid-to-high single digits in percentage terms on an annual basis. Of course, inflation was high, but even allowing for this, real returns were positive over the decade.

Elsewhere, the late 1990s saw the so-called dot-com bubble, with an ever-widening gap between corporate profits and equity valuations. In 2008, we saw the Global Financial Crisis, caused by excessive leverage in the financial system and, over the last year, we have witnessed the economic and financial market fallout from the Covid-19 pandemic. However, despite these period shakeouts, the global economy and corporate profits continued to grow.

Unless there has been a material change in one’s personal circumstances the lesson is to stay invested in the stock market wherever possible, even if in the short term the news flow appears disheartening.

And this brings us back to the present. With the global stock market trading near all-time highs, there are fears that policymakers are in danger of running the global economy “too hot” via excessive stimulus, which could bring back the spectre of inflation for the first time in nearly four decades.

Whilst we share the market’s view that inflation will rise over the next 6-12 months, this reflects last year’s collapse in inflation and the strong bounce back in growth we expect over the next year as restrictions to free movement are progressively eased.

Our baseline view remains that, with inflation arguably too low over the last decade, a rise in inflation over the next two to three years is to be welcomed, given that it is unlikely to feed through into the type of wage-push inflation which characterised the 1970’s. Furthermore, we expect a circa 25% increase in corporate profits globally over the next year, which could grow even more rapidly should economic growth beat expectations.

Finally, although markets may fret about high inflation in the short term, the longer-term disinflationary forces from demographics and technological advances remain in place. Another positive risk for equities is that inflation ultimately turns out to be the dog that doesn’t bark.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Things usually turn out better than we feared

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