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Saumil H. Parikh
Total corporate income (profits) equals total investment less household savings less government savings less foreign savings (see Figure 7).
In mapping this expression to the three components we described above, the return from income is represented by the initial payout-adjusted dividend yield. The return from growth is represented by the nominal GDP growth rate, plus the change in profits’ share of GDP. And the return from valuation change is represented by the change in cyclically adjusted P/E multiples as well as the change in real long-term (20-year maturity) Treasury yields. The addition of real long-term Treasury yields to the expression is important. Because we are attempting to explain equity total returns, and not equity excess returns, the fundamental discounting factor for long-term financial assets (such as equities) must be included and forecasted to produce expected total returns. This departure from simply using a mean-reverting cyclically adjusted P/E multiple will prove to be informative, especially in the New Normal era of negative real interest rates we currently find ourselves in – and expect to stay in over the secular horizon.One interesting realization from this exercise is that the growth rate of earnings per share does not keep pace with that of aggregate corporate profits and GDP growth (see Figure 13). We call this the “equity dilution factor" above. This occurs mainly because economic development and growth are increasingly capital intensive, such that capital-to-income ratios at an economy-wide level need to rise to generate the total factor productivity captured in equity returns. It is also because capital does get destroyed from time to time, due to natural disasters, wars and other known unknowns, which eventually gets borne by equity. While this equity dilution factor is a time-varying concept based on changing phases of economic growth, the inclusion of this factor is important particularly as we look to forecast equity returns across both developed and developing economies with different structures. So what are PIMCO’s main assumptions for broad U.S. equity returns in the New Normal?
Our forecast will change either if we expect nominal GDP growth to accelerate or decelerate from our 4% to 5% baseline assumption, or if we see a substantial shift in the profits’ share of GDP forecast based on a productivity-growth-based resurgence in investment in the U.S. economy, as shown in the forecast table.
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