High valuations may challenge India's 25-year lead in real returns

I had the opportunity to go through a very interesting study put out by Jim Reid and his team at DB Bank, focusing on financial market returns over the past 25 years. The study is exhaustive and filled with data and insights. It looks at returns over the 25-year period from January 2000 to the end of 2024. The following statistics stood out to me.

 

While most of us have come to accept American exceptionalism in the financial markets — with the US accounting for nearly 65 per cent of global equity indices and reaching new highs with back-to-back years of over 20 per cent returns — the last quarter century has not been a particularly great period for US equities in a historical context.

 

In the last 25 years, US equities (S&P 500) have delivered a real equity return of 4.9 per cent per annum, which is the second-worst 25-year return among the nine 25-year blocks going back to 1800. Over the last 100 years, US equities have delivered real annualised returns of 7.3 per cent, making the 4.9 per cent significantly below the long-term trend.

 

How can this be true, given the new highs at which the markets are trading? What about the Magnificent 7 and their dominance of returns? Are we not near all-time high valuations, in the top 1 per cent of market history?

 

The truth behind this poor relative performance of US equities lies in the starting point valuations. The start of the year 2000 marked the peak of the internet bubble, with the S&P 500 reaching its highest cyclically-adjusted price-to-earnings (P/E) ratio in history. Despite valuations returning to near-peak levels today (at the end of the 25-year period) and being in the midst of a bull market, the starting valuations were so high that they created a significant drag on returns. If we look at the entire 25-year period, it took until 2013 for equity real returns to cross the real returns of US Treasury bills (cash proxy).

 

For the first 13 years of the quarter century, real equity returns lagged even cash, once again demonstrating the elevated starting valuation drag. While equities eventually outperform bonds and cash in all markets, given enough time, there have been periods, such as 2000-2013, where this has not held true. While valuation is not a timing indicator, it does play its part in determining long-term returns.

 

While US equities performed poorly compared to their own historical track record, they were still far better than other developed markets (DM) like Germany and the UK, which delivered 25-year real returns of only 2 per cent. These 25 years have also been unique in that, for the first time, gold has outperformed equities over such an extended period. Gold delivered a real return of 6.8 per cent per annum, compared to 4.9 per cent for US equities.

 

This lesson that starting point valuations are very important in determining returns even over a 25-year period is worth bearing in mind, especially given where valuations are currently in the US and India. There is absolutely no scope for earnings disappointments.

 

The second lesson was the total irrelevance of economic growth in determining the equity returns of a country. There is absolutely no correlation. The prime example is China in the 25-year period. This was the golden quarter century for China. It entered the World Trade Organization (WTO) in 2001. China grew real gross domestic product (GDP) at over 8.5 per cent per annum through the 25 years. The Chinese economy in USD terms was only 12 per cent of the US economy at the beginning of 2000, today it is 70 per cent. China went from being 3 per cent of world GDP in USD terms (year 2000) to 17 per cent today. It became the manufacturing base of the world and moved hundreds of millions of people out of poverty. Despite all this progress and its role as the global growth champion, China delivered a real equity return of only 4 per cent per annum over the past 25 years—lower than the US and much lower than India. Quite incredible!

 

As an aside, when China began its reform programme in 1979, its economy was about 10 per cent the size of the US economy in USD terms. It took 28 years for the Chinese economy to get to 20 per cent of the size of the US economy. Then, within 15 years, it gets to 70 per cent. Obviously, the impact of exchange rates and the global financial crisis has exaggerated this, but does it imply that it simply takes that much time for reforms to fully work their way through the economy? India is now in the 30th year of its own reform programme—just food for thought.

 

As for the value of long-term forecasting, an incredible data point is that in 2000, everyone believed that the US would have no federal debt left by 2013 at the latest. It had a federal debt-to-GDP ratio of 32 per cent in 2000, which most thought would be paid off totally. There was concern as to how markets will work in a world with no US treasury debt! Today, we are struggling at debt-to-GDP ratios of 100 per cent. This highlights the sea change in attitude towards fiscal imbalances and tolerance for debt today compared to 25 years ago. The report also looks ahead to the next 25 years, from 2025 to 2049. The biggest takeaway when considering the coming quarter-century is the significant impact of demographics. This will be the first quarter-century in which 26 of the 57 major emerging market (EM) and DM countries will experience declining working-age populations. Sixteen out of 24 developed countries will experience shrinking working-age populations. China, in particular, will see a decline of 225 million in its working-age population. Japan will see a decline of 18 million, Korea 12 million, and Germany 10 million. The EU as a whole will see a decline of 70 million workers. The US sees a small increase of 8 million. India stands out with an expected increase of nearly 150 million workers over the coming quarter-century. By 2050, India will have a population about 30 per cent larger than China’s, with a working-age population 50 per cent higher. This is India’s demographic sweet spot. We have to skill and create jobs for this cohort. As supply chains move to diversify away from China, only we can provide the scale needed. We must clear the policy and factor-of-production hurdles that are preventing mass manufacturing coming to India. Demographics and geopolitics make this an unbelievable opportunity for India.

 

Until now, the only large countries that have experienced declining working-age populations are Japan, Germany, Italy, Portugal, and Greece during the 2000-2024 period. These five countries have also experienced the weakest growth. Europe risks going into a period of no growth unless immigration comes to the rescue, though the politics of this seem impossible at the moment.

 

Another noteworthy data point is the stability of Indian equity returns. Over the last quarter century (2000-2024), India delivered the best real equity returns of any major equity market, with a real return of 6.9 per cent per annum, outperforming the US. Even looking at 50 years of data (1975-2024), India at 9.7 per cent real equity returns outperforms all other EM countries and even the US. Only Sweden at 9.9 per cent real returns outperforms India. We have clearly established the ability to deliver strong equity market returns — and over an extended period. This is a fact that most global investors do not yet fully appreciate.

 

The next 25 years will be challenging for the world and equity markets. The US and India face the challenge of high starting-point valuations, while Europe grapples with poor demographics and slowing productivity. China was unable to deliver returns when its economy was on fire, and today it faces geopolitical challenges. We also have the elephant in the room of world debt-to-GDP having risen by 100 points in the last 25 years to 330 per cent. How will this get resolved? Is there any natural ceiling?

 

The author is with Amansa Capital