Staying the course by staying invested
Staying the course
by staying invested
After the market sell-off last week, when the US equity market fell 9.7% (on an intra-day basis) and Japan’s Nikkei fell 26.6% from the mid-July highs, markets have recovered quite robustly. Still not back to the July highs, but the calm after the brief storm does come as a relief. Such sell-offs are not infrequent.
The chart below shows that in a typical year since 1980 US equities (as tracked by the S&P 500), tend to have a fall of around 14%. Despite that, the average return each year of 10.4% reflects the underlying resilience of profits growth over the past 44 years. Investors with longer memories may remember the 1990’s when the typical intra-year loss averaged 10%, however, the past two decades have seen higher losses. Investors seeking equity market returns have had to become more tolerant of episodic risk and higher periodic losses.
US equities: annual returns and intra-year declines. US equities have historically returned robust long-term returns despite intra-year losses of over 14%.
Source: Artorius
The key takeaway from history is that US equities (and other equities), often fall by more 10% in any one year, but staying invested over time has generated robust returns for patient and risk tolerant investors. We suggest that longer term declines of equities are driven by inflation and earnings.
Inflation and interest rates: yesteryear and today
It is fair to highlight that the valuations of US equities remain elevated. On 21x Price-to-Earnings (PE) ratio, US equities are towards the top end of their valuation range. This is the main reason why investors should expect lower future returns (we suggest 6-7% per annum) compared to the historical 10% enjoyed since 1980. However, high valuations do not result in near-term losses for investors.
The key drivers to equities over time have been a combination of profits growth and valuations. The latter tends to be a function of interest rates. Low interest rates tend to lead to higher valuations, and higher interest rates tend to reduce valuations. When equities fell 19% in 2022, this was primarily down to higher interest rates.
In 2021, inflation proved to be more persistent at a higher level, which resulted in interest rates rising from zero to 4.25% in the year. 10-year government bond yields rose from 1.5% to 4% (which resulted in sharp losses for government bond investors). Higher interest rates and bond yields contributed to the valuation of equities falling from a very rich 23x PE ratio to 17.5x PE through the year.
So it was with interest that investors received the latest US inflation data this week. It showed that inflation continues to moderate. Whilst above the 2% rate that was normal pre-Covid, investors took comfort that the 2.9% year-on-year inflation rate will enable the Federal Reserve to cut interest rates through to the end of the year, starting at the mid-September meeting.
US inflation: after a hiatus inflation has eased lower in the past few months, opening the door to interest rate cuts
Source: Artorius, Bloomberg
Indeed, investors appear to expect 4 cuts (or interest rates being reduced by 1 percentage point) by December 2024. This feels too optimistic in our view given that the economy is slowing but still growing and Federal Reserve officials have indicated that they would like to see further easing of wage and inflationary pressure. But in contrast to 2022, when higher rates triggered a fall in equities, investors are likely to welcome lower rates through the next few months and tolerate elevated US equity valuations - as long as profits keep growing.
Profits picture
Most bear markets (equities falling by more than 20%), tend to be driven by prolonged declines in profits. So, alongside inflation and the implications for interest rates and equity valuations, recent weeks have seen companies update the market on their quarterly earnings. Overall, earnings have beaten expectations. The extent to which companies have beaten expectations is less than has been the case in recent quarters, and there has been a noted tempering of the outlook for the rest of 2024.
Somewhat surprisingly, the expectations for US profits for 2025 have continued to climb. Overall expectations for profits (as measured by Earnings per share, EPS) for 2025 remain good, and suggest a 15% growth in profits next year after 14% growth for 2024.
We note that whilst the outlook for the US economy is muted, but not recessionary, the profits outlook is robust.
Estimates for US profits (as measured by Earnings Per Share EPS) continue to climb for 2025 and remain resilient for 2024
Source: Artorius, Bloomberg
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Conclusion
Investors should expect intra-year volatility and sell-offs in equities. Typically, US equities see a 14% sell-off each year, despite returning 10% per annum since 1980. Patient investors with risk appetite should stay invested and not change course when short-term volatility arrives.
Markets have tended to sell-off either when interest rates go up or profits fall. In coming months, it appears that interest rates will be cut, as inflation pressure eases, and profits growth expectations remain upbeat, and indeed improving for 2025.
Gerard Lane
Chief Investment Officer
Important Information
All expressions of opinion reflect the judgment of Artorius at 16th August 2024 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Nothing in this document is intended to be, or should be construed as, regulated advice. Artorius provides this document in good faith and for information purposes only. Reliance should not be placed on the information contained within this document when taking individual investments or strategic decisions.
Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.
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