They thought it was all over – it isn’t yet. Kicking the can down the road has been the policy response du jour, only now the can is getting bigger and becoming harder to kick each time.
Central bankers are preparing to refine and reload their monetary weapons as a deeper dip hits the UK economy and Eurozone woes prove to be contagious. Meanwhile, investors are left to ponder when all this will be over and where to put their money in the meantime and/or for the long term.
The chart shows the cumulative total return from various asset classes since 1999:
This time period encompasses the dotcom, subprime and eurozone busts as well as the mid-noughties boom fuelled by cheap, abundant credit and strong growth prospects. Emerging market equity (hedged back to sterling) has been the standout performer, while UK and ‘world’ equities battle it out for the wooden spoon, each returning less than a risk-free benchmark (3 month Libor in this case).
When we dig into the data a little further, a contradictory result shows up:
– risk/return theory appears true as EM equity brings highest return but also highest volatility
– risk/return tradeoff is turned on its head as lower-risk gilts outperform higher-risk UK equity
A few other points of note:
– Gilts, index-linked gilts (“linkers”) and sterling non-government debt have provided a positive return in every period analysed
– They have done this with much lower volatility than UK/World/EM equities and commodities
– Gilts and linkers have seen their strongest performance in last 12 months
– Equities show solid performance over 3 year period (FTSE bottomed in March 2009!) but are flat/negative over 1 and 5 years
The Sharpe Ratio is used to show how well the return from an asset compensates an investor for the risk taken – the higher the number the better. Credit assets have shown much higher ratios than equities and commodities across all time periods, with the latter both showing negative ratios at certain points.
Debt v Equity Conundrum
For long-term investors, the actual performance of equity since 1999 has been far below returns expected from the asset class. The debt-versus-equity question grows ever more puzzling to answer – can bonds continue to show higher returns with lower risk even at these high prices/low yields, or will the next decade break from the last?
Since the Great Financial Crisis (GFC) began in 2008, equity markets have been buoyed by each new monetary policy boost and the promise of cheap lending by central banks for the foreseeable future. Bond prices have also been buoyed by central bank actions, in addition to support from falling inflation rates, regulatory changes, a search for yield and the need for liability-matching assets by pension funds and insurers.
It appears the GFC is not over yet and that investors grow more concerned about a disastrous outcome. For example, certain European government bonds are trading at negative interest rates, meaning that investors are willing to pay these governments to buy their debt. It should be noted that it is investors, not issuers, who are driving these bond yields ever lower (prices ever higher). Negative rates have not yet reached the UK but were they to do so, gilts which seem overpriced now may become even more so – after all, the market can stay irrational for longer than investors can stay solvent!
Signs of the times
Barring the doomsday scenario some are predicting for financial markets (in which case you are better off spending your long-term savings than accumulating them), what signs might investors seek for a turnaround in the economy?
1) Europe agrees on a robust and permanent solution, with German and Greek leaders swearing on each other’s economic wellbeing that they are in it together
2) Banks stop deleveraging and start extending credit, with cheap cash from quantitative easing and funding-for-lending schemes actually being passed through to consumers and companies
3) UK GDP turns positive and ends the recession, with a return to pre-GFC levels of interest rates and equity prices in the foreseeable future
4) Unemployment rates begin to fall, with new job growth providing increased tax receipts to and spending power for the government
A number of economic hurdles need to be cleared before a lasting recovery is in place and it could take a number of years before an end to the GFC is declared officially. With monetary bazookas being central bankers’ weapon of choice and fiscal austerity being used by politicians, it may turn out that credit assets continue to post positive returns while equities grapple with what the debt crisis and its solutions mean for longer-term stock valuations.
Investors should be aware of the economic and policy risks still in play, they may not be as lucky as Geoff Hurst and his goal in 1966!