Free Press Journal

Why tomorrow may not be


Equity investors in emerging economies like India need to work with new parameters to maintain success, writes TENSING RODRIGUES.

Why tomorrow may not be what yesterday was, is the theme of the report released by McKinsey Global Institute early last month; the principal message of the report is: “over the next 20 years, total returns including dividends and capital appreciation could be considerably lower than they were in the past three decades.” The message could be crucial for equity investors in India.

Of course MGI is reporting on US and Western European economies; and the same may not be true of the rest of the global economies. Yet, it makes sense to look into data this prognosis is based on, and the rationale of the report. For today no economy is an island; and truer than that, no market is an island; despite all the decoupling that is supposed to have taken place post 2008. Moreover, we have got to look for the possibilities of any positive outfall of this slow down, for economies like India. Because it is impulsive to take one of the two extreme positions: because they are slipping, we too are likely to slide down; or, because they are climbing down, we are likely to climb up. Either can be far wide off the mark. For the linkages between the economies are too complex to arrive at such facile conclusions.

The period 1985 to 2014 has in no way been a joy ride for investors; we have seen two equity market collapses, one in 2000 and another in 2008; the New York Stock Exchange faced the history’s fastest single-day drop in 1987; Asian crisis rippled through the global economy in 1997, spreading to Russia and Brazil by the next year; and finally in 2008 a global financial meltdown threatened to wipe all that the 30 years had gained. But yet, what the markets delivered to the investors in these thirty years was unprecedented in economic history.

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Just see the comparison: in the 100 years between 1915 and 2014, US equities returned around 6.5%; in the 50 years between 1965 and 2014, they returned around 5.7%; and in the 30 years between 1985 and 2014, they returned around 7.9%. The corresponding figures for Western Europe were 4.9%, 5.7% and 7.9%, respectively. Mind you these were real returns, net of inflation. The 30 year bonanza was a result of falling inflation, declining interest rates, strong GDP growth and robust profit margins.

With the oil prices becoming more predictable and less shocking, and most of the governments easing liquidity, the inflation took a retreat. In the US, for instance, average annual consumer price inflation was around 2.9% over the 30-year period, as compared to the 50-year period inflation figure of 4.3%. Inflation determines real equity returns by way of the payout ratio and its effect on the PE ratio; the average payout ratio in US and Western Europe rose from 57% to 67% from the beginning to the end of the last three decades. The rise in PE ratios post the inflation ridden 70s and 80s contributed significantly to the higher equity returns in the decades that followed.

The deceleration in the US and Western European economies delivered unexpected benefits to the investors. A slow but certain contraction in investment coupled with higher savings, flushed the money markets with liquidity, pulling down the interest rates. To add to it most of the central banks dropped the interest rates, which in many countries are negative now. Global interest rates declined by about 4.5% 1980 and 2015. Consequently the fear of future inflation also decreased, taming the risk premiums.

The slowdown in growth in the US and Western European economies shrunk the demand for capital goods, and consequently their relative prices. This was aggravated by a reduction in public investment. All this reduced pressure on interest rates. The share of investment in GDP of US fell from 24% of in 1985 to 20% in 2014. As a result of falling interest rates the US companies saved about 40% of their outgo in the 30 year period; that added about 1% to their post-tax profit margin.

A steady growth in GDP of about 3.3% over 1985 to 2014 turned out to be one of the key drivers of corporate revenue and profit growth helping to boost equity returns. Two of the most decisive reasons for GDP growth were the brisk growth in the working-age population (15 -64 years) and employment growth. According to the McKinsey report, in G-19 and Nigeria, the share of the working-age population climbed from 58% in 1964 to 68% in 2014; employment increase in these economies contributed about 48% of their GDP growth; employment in the United States grew at an annual rate of about 1.4% between 1985 and 2014, contributing slightly less than 50% of GDP growth. In China and other emerging-market economies employment more than doubled during this period.

Rising productivity was responsible for 52% of global GDP growth between 1964 and 2014. During this period productivity in the US grew at an average rate of 1.5% and in Western Europe at 1.8%. The most important driver for the productivity growth was the sectoral shift from low-productivity agriculture to high-productivity manufacturing, and subsequently to service sector. Growing automation and increasing integration of the global economy resulting in efficient geographical division of labour also contributed to productivity enhancement.

Increases in profit margins have also contributed to the equity price appreciation in the past three decades. Globally after-tax operating profits of the companies rose to 9.8% of the GDP in 2013 from 7.6% in 1980, an increase of about 30%. What was even better was the net income growth, rising to 70 percent of the global GDP. More than half of this went to US and Western European companies. Margin growth came from several quarters. Ironically, one of the most important of these was the booming consumer class in emerging markets. Another important factor was the economies of scale as volumes increased and the cost cutting technological advances. Modest reductions in tax rates also contributed to improved margins.

However, beginning the middle of this decade, a lot of these favourable conditions have reversed. Inflation is slowly rearing up its head; interest rates can fall no further, and, in fact, may slowly creep up as the risk premium mounts; global GDP is on the decline now; and, the profit margins are under pressure. Tomorrow may, therefore, not be what yesterday was. Equity investors in emerging economies like India need to work with new parameters.

(McKinsey Report source: