Looking ahead

It has been a little while since our last note, during which time markets experienced a very modest correction before ascending to new highs once more. It is clear that we are still, particularly in the US, in a very strong bull market.

In the very short term, sentiment measures are suggesting some complacency right now, and we are always open to the possibility of a correction. However, we are not unduly concerned, and we continue to maintain a positive stance, with an overweight equity position in portfolios.

That said, it is worth tempering expectations, with the global equity market up c.25% year to date in euro terms. We should remind ourselves that long-term returns from equities have averaged c.6-7% per annum (after inflation) and many believe returns will be lower than this over the next decade.

Having said that, many also believed returns would be lower than average 10 years ago and that hasn’t been the case at all. However, as we look forward it seems sensible to expect lower returns given today’s starting valuation and the return available from ‘risk free’ bond assets.

When considering future returns, clearly one of the major drivers will be earnings growth and this is a topic we find fascinating today.

There is a cogent argument that earnings are currently above the long-term trend, which would argue for modest returns over the next decade and arguably more defensive positioning. Whilst this view has been articulated for many years and has been very costly for those who were under-invested in equities as a result, we do recognise its merits.

However, in our view, any debate about future earnings growth, needs to also consider the pace of innovation we see today. Since our last note, we hosted a series of webinars discussing technological changes in energy and healthcare, as well as change at a broader economic and societal level. Please ask if you would like to receive a link to these webinars.

These conversations served to underscore our conviction that the next decade will present wonderful opportunities and significant risks.

Bringing this back to earnings growth, if the global economy is set to undergo one of the greatest periods of change in history, it seems obvious that attempting to project earnings growth over the next decade is quite challenging, to put it mildly.

Indeed, looking at average earnings growth may not be that helpful, given that it is likely that we will see continued divergence in earnings trends between the companies that are being disrupted and companies that are benefitting from, or driving, change.

Of course, the nature of market indices will mean that companies in the ascendancy will become bigger parts of the indices. A passive index investor will find their portfolio weighting towards ‘winners’ over time and this trend has been a clear driver of the outperformance of US markets over the last decade.

Whilst broad market indices will allow investors to benefit and capture some of the value generated by companies driving change, we continue to believe there is merit in allocating to companies and strategies that are more proactively investing in innovation and thus likely to capture a higher proportion of future earnings growth.

As you might expect, we are not alone in this thought, and it is not surprising that companies with better earnings prospects have outperformed the market in recent years and trade on notable valuation premiums. We, therefore, need to be very conscious of the risk of overpaying for growth.

Whilst valuation discipline is an important foundation of our approach, if the economy is truly set to experience a technological revolution as profound as the industrial revolution over the next decade, there will be enormous valuation creation, which is not reflected in company earnings today.

For our part, we feel compelled to understand the potential ahead of us. Innovation is palpable across every industry, and we have to challenge ourselves to understand the investing implications.

This does not mean that we throw caution to the wind and seek growth at any price. However, any analysis of earnings growth and potential future returns has to consider the pace of change.

Perhaps earnings growth will trend lower, and returns will be lower than long term averages. However, we must also consider the potential for stronger than expected earnings growth driven by technological progress.

Unfortunately, we can’t predict the future, but we believe pragmatic optimists will be rewarded over time and our research leads us to believe that we are only in the foothills of the current technological revolution.

As always, please do not hesitate to contact us to discuss our views further.

Ian Quigley
T: +353 1 2600080
E: ian.quigley@brewin.ie

www.brewin.ie

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