With the US needing to borrow huge sums to fund its taste for overseas goods, its economy like others will be unable to match the returns that were seen in the 1980s
New paradigm. It's been a while since that phrase was bandied about. Investors became used to dizzyingly strong rates of economic growth in the late 1990s and all the time with none of the significant problematic accompaniments of old, such as inflation.
Disinflation ruled as productivity boomed and new technology allowed production and transaction costs to fall. Investment returns for UK equities were positive for eight out of 10 years in the 1990s and all of those positive years were in double digits. A compounded annual rate of return of nearly 15% was achieved over the period. Gilt returns had a similar profile, eight out of 10 were positive with a compound annual return of over 11%.
Then it all came crashing down and the West's authorities are still picking up the pieces in an attempt to prevent a deflation-led depression. The two asset classes have diverged dramatically. Equities ' three down years: Bonds ' three more positive years.The question is where do we go from here?
From an economic perspective it is so far so good, at least from the Federal Reserve. US growth has remained positive and prospects for the future are improving. However over the next few years there are still problems to be addressed. The US continues to borrow at an alarming rate, be it in the form of increased private sector debt, huge tax cuts that raise the fiscal deficit or through the requirement of a $40bn plus per month capital inflow to sate its appetite for overseas goods.
With capital investment having been to the fore in the boom and a substantial capacity overhang still in place, reluctance to spend on the part of companies is understandable. Interest rates have been slashed to encourage consumers to spend thereby sustaining economic growth. Consumption makes up fully two-thirds of US GDP so keeping people spending is very important to the overall economy.
The UK has been in the happy position of benefiting from interest rates at levels not experienced in a generation and more. Cheaper mortgages have led to another housing market boom, which unlike last time has not been and is unlikely to be spiked by rising interest rates.
However, greater competition, more price transparency and increased freedom of trade have combined to make raising prices very difficult. As prices get squeezed it becomes harder for companies to deliver the better and better results that investors so greedily demand. Cutting costs is one way to improve the bottom line, but that often involves cutting staff. In isolation that may be fine for your company but if your customers are doing the same then ultimately the number of end-customers dwindles and aggregate demand slips away. And the spiral downwards begins. A new paradigm indeed.
Reduced pricing power leads understandably to lower inflation. Lower inflation has been a policy objective of central banks globally and their ability to reach those goals has improved as a consequence of the general environment. With that ability has come improved credibility and increased public belief in a low and stable inflation outlook ahead. This combination of lower actual, lower prospective and less volatile inflation has been a major reason why bond yields have fallen so far.
Low bond yields remain attractive only as long as they continue to fall. Gilts that yield 4.5% or less will not be in demand for long if that nominal yield is all that they return. It would need a further fall to less than 4% over the next 12 months to double that return to 8% and a fall back to 3.5% yield to produce the popular 10% threshold. Corporate bonds have proven popular too recently. Companies have to pay higher rates than governments to borrow so bond yields from these issuers are higher. A diversified portfolio of investment grade corporate bond may yield about 5% but a deteriorating gilt market will also undermine the corporate market.
The apparent tameness of inflation and the ongoing assertion by many commentators that the beast has been slain has allowed interest rates to be cut to historic lows. With bank base rates at 3.5% and deposit rates generally no better than 3.25%, returns from cash do not set pulses racing.
So the question becomes, where can investors get a meaningful and attractive return in today's financial markets?
It seems reasonable that in the long run companies should be able to grow their profits by a rate similar to the rate of expansion of the economy. Real GDP is probably capable of growing at a trend rate around 2.5% per annum without encountering inflationary bottlenecks. No new paradigm there. Adding the target rate of inflation, also 2.5%, leads us to a nominal GDP growth rate around 5%. Companies tend to strive for productivity and efficiency so there is probably an additional 2%-3% profit growth available in general, meaning equities should be able to generate about 7%-8% improvement in their bottom line each year.
In the past the price that people are prepared to put on those profits (or earnings) was bid up and up, leading P/E ratios to new heights. This measure of market valuation has fallen back but has not reached the lows of previous cycles and in the US, has barely fallen back to the long-term average, hardly cheap. Property has become increasingly popular as an asset class in the UK. Returns have been consistent, positive and high in recent years and with features such as upward-only rent revisions, returns are forecast to remain in the 6%-9% range for the next few years. Obviously, the general health of the economy is a major influence on the property market but the UK does not seem set to suffer unduly in the current climate.
Investors therefore need to appreciate that without some new wave of increased productivity or another technological breakthrough that rewrites the way business is done, investment returns can only be unexciting on the whole in the medium term. However, there will undoubtedly be periods of rapid gains interspersed with setbacks and consolidations. Buy-and-hold strategies of old for equities are not the best tactics in this environment. Bond yields care unlikely to return to recent low levels in the short term and therefore will struggle to provide returns in excess of the quoted yield in the absence of deflation, which most central banks have vowed to avoid. Cash rates seem set to remain low for the foreseeable future.
One thing is clear; the impressive supplemental benefits that we all gorged on as inflation and bond yields fell are not going to be repeated any time soon. This is certainly one case of it being better to travel than to arrive and the new paradigm is one in which bountiful investment returns are tough to achieve.
The boom years of the 1990s saw equities soaring but since then bonds have been the stronger asset classes.
US growth has remained positive but underlying problems of high borrowing and overcapacity remain.
Greater competition, more price transparency and increased freedom of trade has led to a low inflation environment.
Equities should be able to generate 7%-8% in their bottom line per year.
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