Expectation of Future Investment Returns

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.

Mike Grant


When is a default not a default?

When it is a Greek debt restructuring deal! This is the largest bond swap in history with the majority of private investors such as banks and pension “voluntarily” accepting up to 74% haircuts worth around £90 billion in total. This slashes the Greek debt burden and triggers a further £110 billion in loans from the so called Troika (IMF, EU and ECB). The question is is this a default? The D word is feared by the markets, central bankers and politicians alike due to upstream losses and fears of contagion.
The answer lies with the controversial “Collective Action Clauses,” that the Greek government can impose on the miscreant bondholders who do not want to accept the write downs. Ratings agencies say if these are invoked Greece will be in default. Further ISDA, the International Swaps and Derivatives Association is due to decide if the credit event will trigger Credit Default Swap (CDS) payouts? You will recall these are insurances taken out by bondholders to cover default risk. By definition a claim on CDSs means default and losses for the CDS issuers and could trigger further sell offs in the bond markets although some argue these events are already priced into markets.
If successful this deal could be a key step in stabilising the EuroZone and the financial crisis in government debt together with the second tranche of easy money from the ECB. The focus may then shift to the fundamentals of the global economy. My feelings are that the debt crisis is not over yet and interesting times are ahead.
This post is not recent and some information is out of date

Cash Savings & Comparison Website

With inflation falling, cash now offers better real returns. In addition increasing competition for cash savings is leading to higher interest rates and better terms, for example on accessibility or not employing temporary bonuses. These attract customers with high interest which tumbles to a paltry rate after six months or a year at the end of the bonus period. Deposit takers have historically relied on customer apathy not to move monies. Shockingly many accounts may be offering rates as low as 0.1% gross or 0.5% p.a. gross. Do you know what you are getting on your cash savings?
With the market hotting up it is now a good time to review the interest you receive on your cash accounts. I know shifting money can be a hassle but it is worth the time with large deposits. For example if you can secure an extra 1% p.a. gross interest on £50,000 this equates to £500 before income tax. Not to be sniffed at. Further with rates on the best accounts paying around 3% p.a. if you are receiving 0.5% p.a. currently the reward for the effort of switching is a no brainer.
A further incentive to consider savings now, applies to those seeking to use Cash ISA allowances for 2011/12. Time is running out before the end of the tax year. To this end I wish to recommend a comparison website I have learned about – www.savingschampion.co.uk . Whilst there are other good sites such as MoneyFacts and Moneysupermarket that I have referred clients to, this one is refreshingly simple with excellent content, high clarity of display and ease of use. The two female founders also have a background working with IFA firms, Anna Bowes as an adviser so I guess that is an added attraction for me.
Please note Montgo Consulting Ltd does not verify the accuracy of the content or take responsibility for third party websites

Equity Markets Rally

You will have noticed that equity markets have rallied in recent weeks. This is due in part to the European Central Bank (ECB) firing its “big bazooka” at the end of December, with unprecedented buying of government bonds and injecting liquidity into the financial system. The result has been a very large reduction in sovereign bond yields, notably in Italy and easing of bank funding pressures. At the same time positive economic data from the US including falling unemployment has cheered the markets. However frequent comments have been made that central bank and government fiscal measures to address the EuroZone debt crisis has merely been kicking the can down the road, meaning the symptoms, such as liquidity and access to credit are being treated not the underlying causes. There is simply too much government debtedness which will not go away overnight.

The UK has just been placed on negative watch by Moody’s with a risk that its coveted AAA credit rating faces a potential downgrade in the next 18 months. However the UK is in a stronger position than many developed economies for various reasons. Firstly much of our debt, in the form of government bonds or gilts is long dated and therefore the UK does not face short term refinancing pressures like other economies. Secondly there is more scope in the UK for the use of “financial repression,” which are processes designed to keep bond yields low. An example of a tool for this is Quantitative Easing (QE). This reduces the cost of government borrowing, making debt repayments easier and also contributes to inflating an economy out of debt. Despite the UK’s safe haven status the key problem with the UK is anaemic economic growth.

To date the crash in global stockmarkets that I feared in the autumn has not materialised. However given the observation above that the underlying causes of the EuroZone debt crisis have yet to be addressed the capacity for a shock remains. Right now I am happy to remain in cash although I am pondering other low risk assets for my pension funds.

 This post is no longer recent and some information is out of date.