There are plenty of reasons to believe that the outlook for developed-market equities over the next decade is poor. As we recently pointed out in a cover story, retiring baby boomers are one potential headwind. Another is market history, which shows that stocks move in long, multi-year cycles from very high valuations to very low ones. Since peaking in 2000, markets have not hit the rock-bottom valuation lows typical of major bear-market bottoms.
Then there’s the macroeconomic backdrop, with years of deleveraging likely to be needed to work off the debt load incurred in the credit bubble and thus lay the foundation for a sustainable upswing. A recent note by Morgan Stanley’s European Strategy team highlights another likely problem: a structural decline in corporate profitability. Margins have been “in a sweet spot for the last 20 to 30 years”. Non-financial, pre-tax profit margins in America, for instance, hit a 40-year high above 8% at the peak of the credit boom and recently approached that level again. But now they look set to trend down.
Five factors have driven the long-term rise in margins, says Morgan Stanley. Technological changes have lowered costs and bolstered overall efficiency. The long-term downtrend in interest rates since the early 1980s has reduced borrowing costs. Corporation tax rates have also been in secular decline for 30 years. Outsourcing has taken off across the developed world, lowering costs. Finally, in the 1980s and 1990s, commodity prices fell in inflation-adjusted terms and thus eased pressure on margins.
But these tailwinds now look likely to fizzle out or become headwinds. Huge deficits imply higher corporation taxes in the longer term. Across much of the West, interest rates have nowhere to go but up. Commodity prices are likely to stay high as Asian development stokes demand. Outsourcing appears to be “in its latter stages” as emerging-market wages are on the rise.
Finally, we can’t count on the pace of technological change in the next decade or two matching the rapid advances of the last 20 years, such as communications improvements and the internet. Equity valuations “generally tend to mirror trends in profitability”, says Morgan Stanley. So a structural decline in margins is another reason to expect equities to struggle in the years ahead.