In the UK, the first three months of 2004 have drifted by, with little apparent change. After last y...
In the UK, the first three months of 2004 have drifted by, with little apparent change. After last year's collapse of confidence and sharp, faith-restoring bounce a pause for thought seems natural. Last year felt unusual. Stock markets do not often contemplate imminent collapse during a year and then end the year considerably higher. I can think of only two other years in the past 100 when this happened, so I hope it is safe to assume last year will not be the norm. So what to expect from the next five years; should we take the last five, 10, or 25 years as normal?
The past five years have seen nominal economic growth stable at around 5.5%, with real growth averaging 3% and inflation averaging 2.5%. House prices have shown their (apparently) usual strong growth, and consumer debt has grown at its (apparently) usual rate, taking it to unprecedented levels. Government spending has grown around 5% faster than inflation, and taxes have crept up a little.
Having assumed the world was a safer place without a cold war, al-Qaeda has given us something new to worry about. Five years ago the UK stock market yielded 2.5%. Five years later dividends had barely changed (despite five years of economic growth) and the FTSE All-Share Index had fallen by around 4% a year.
The past 10 years have been similar to the past five - interest rates, economic growth, inflation, house prices and consumer debt growth have all behaved in much the same way. There has been no recession. But government spending has only accelerated in the past five years, and long gilt yields have fallen further - 10 years ago they were 6.5%. Ten years ago the stock market yielded a little more than today: 3.5%. Dividend growth subsequently averaged just under 2% per annum. The FTSE All-Share Index rose an average of 3% per annum.
However, 25 years ago things were quite different. Base rates were 9% and long gilt yields were over 11%. Inflation was still above 5%, nominal economic growth was over 9%. House prices and consumer debt were a lot lower. The Cold War was still around but the Middle East worries were confined largely to Palestine. Since then, nominal economic growth has averaged 7%, but was much higher in the earlier years. Inflation averaged 4%, but was also higher in the earlier years. The stock market yielded 4.6% and dividends grew by an average of 6% a year. The FTSE All-Share Index rose by around 10% a year.
So, what to expect next? Another five years like the last five would imply a market 20% lower, negligible dividend growth, but an economy pottering along quite nicely. The market would yield just over 4% in five years' time - plausible given the market has spent around three quarters of the last 80 years at yields over 4%.
How plausible is negligible dividend growth? In more than half of the five-year periods since 1920 dividend growth has lagged nominal economic growth; in a third of the five-year periods it has lagged inflation; one in every eight of the periods dividends have contracted. A combination of economic growth driven predominantly by government spending and a profit squeeze like the one we have seen over the past five years makes negligible dividend growth plausible.
More years like the past 10 wouldn't be bad. An average capital return of 3% plus some dividend yield isn't too shabby. But the past 10 years required some dividend growth, and also got help from declining long bond yields. If bond yields are to come down further, inflation will have to be considered all but dead. This is not a good environment for dividend growth, since it implies almost no pricing power for firms. However, with a little help from heavily indebted US consumers and rapidly developing behemoths like China, some dividend growth could be possible, with a bit of inflation. The main risk is an acceleration of inflation as commodity prices run out of control.
Five more years like the past 25 seems the least likely. Dividend yields are considerably lower than 25 years ago, and so are dividend growth prospects, given how much lower inflation is. There can be little prospect of similar help from the bond market with rates having already halved.
Draw your own conclusion, but I think the experience of the past five years is most relevant. There are risks to the upside if we can get some dividend growth going. There are risks to the downside if consumer debt starts unwinding or we have a recession.
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