In the same week I have seen polar opposite opinions on expectations for future returns from equities. According to Citigroup the FTSE 100 index will double in value in the next 10 years. That takes some faith given the index is still trading at around 1,000 below its December 1999 peak of 6,930. The drivers will be earnings growth, strong balance sheets, high cash balances, mergers and acquisitions and a focus on shareholder benefits. This argument has some legs; it is clear the corporate sector is in rude financial health and sits on a large cash mountain.
Against this conclusion is the house view of Newton fund managers, part of BNY Mellon who wrote an excellent and thoughtful analysis on expected investment returns from developed economies. Their thesis is that since the banking and credit crisis in 2008 it is clear we are in a very different world to that which prevailed in the previous 30 years. Here they cited the great bull market from the early 1980s to the early 2000s driven by falling global inflation, lower bond yields (these lower discount rates on future cashflows and hence supported higher prices for financial assets), loose monetary policy, globalisation, deregulation and financial innovation. It was also a period of relatively muted volatility compared to the 1960s and 1970s. According to Newton* we had super normal total returns of 17.2% p.a. from UK equities over a 20 year period from 3/12/80 to 31/12/00.
Newton argue we are now in a radically different world with an extended period of deleveraging (debt repayment) which will not progress smoothly. Western authorities are in a trap, unable to save or grow their way out of debt and will focus on treating its symptoms rather than the root causes. They are struggling to maintain bubble era levels of activity and asset prices to support unprecedented levels of debt. In this environment debt will be a significant drag on economic growth.
Newton also argue “risk free” interest rates on government bonds are artificially low and their risk is mispriced. The banks have changed from being agents in the economy to being principals, they are too leveraged, still too big to fail and carry systemic risk. The global financial system is comprised of a web of carry trades** whilst financial innovations such complex derivatives, high frequency trading, hedge funds and structured products (with their attendant counterparty risk) which account for much day to day market trading has created heightened volatility.
This analysis predicts low investment returns and high volatility in an environment of structural rather than cyclical over indebtedness and unsustainable sovereign finances.
The shift of realities is a game changer when it comes to investment returns. During the great bull run, risk was being out of the market, not owning financial assets such as equities, bonds and property. This was the era that passive or index investing was born and thrived with many active fund managers struggling to outperform trend returns which were on a upward trajectory. In the new paradigm capital protection, losing less in the more frequent periods of asset falls may be more profitable than chasing returns. A focus on not losing money means absolute return strategies are required whilst index based returns and benchmarking to “risk free” government bonds will be unfavoured.
Active flexible asset allocation and management will be required, traditional asset correlations may prove unstable, certain hedging strategies may fall foul of regulatory authorities and a focus on volatility as the major risk may be dangerous. Two examples were given. Firstly in the late 1990s during the technology boom equity volatility was at low levels but this proved to be a poor measure of risk as the subsequent bursting of the bubble proved. Similarly in March 2009 at the nadir of equity markets, volatility was very high and risk reduction suggested. In reality selling rather than buying equities would have been a poor decision as the subsequent rally proved.
Newton also emphasised the prime importance to total returns of the compounding of re-invested income. Robust and sustainable income streams are likely to matter more and prove less volatile. Unconstrained forms of investing should also be favoured.
In conclusion Newton said if they are correct then we are in the early stages of a major transition in attitudes; if wrong we are in the foothills of another structural bull market. Time will tell who is right Newton or Citigroup. Newton’s analysis feels right to me but their thesis is focused on developed economies of the West. As emerging markets continue their inexorable economic growth decoupling can be expected and this may drive a global bull market. You will be aware for example that significant earnings from FTSE 100 companies arise from emerging markets. Consequently Newton’s view may be too cautious.
What is clear to me that there is evidence of Newton’s thesis playing out in the last decade, with indices moving sideways, high volatility and active fund management being favoured. Interesting times lie ahead.
* Source: Thomson Reuters Datastream; total return of FTSE All Share Index.
** Carry trades are strategies where investors borrow money at a low interest rate to invest in an asset that is likely to provide a higher return. It includes currency investments.