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February/March 2013 Investment Analysis: The Lost Decade

Written by Andrew Holt
Feb/March 2013

The Lost Decade

In association with Sarasin & Partners

Goodbye to all that wrote Robert Graves, and many have already said a very welcome goodbye to the 2000s, when the stock-market punished investors with an up-and-down ride that delivered no overall gains, and are now widely referred to as the lost decade, going down as one of the worst 10-year investment periods ever for equities. During this period, the S&P 500 registered two plunges of more than 50 per cent and several of more than 10 per cent, leaving this index slightly lower today than it was over 12 years ago. An investment in the FTSE 100 would have fallen in value by 4 per cent. There have
been the peak-trough-peak-trough cycles of 2000, 2003, 2007, and most recently the lows of 2009.

Has this disappointment ended? There does appear a rising optimism and much reason for it: partly due to the disaster scenarios of a break-up of the Eurozone and the dive over the US fiscal cliff failed to come to fruition. Added to this, post-crisis adjustments have occurred with house prices rebalancing and possibly a rising trust in the competence of central banks to have used expansionary monetary policies to pull along the economies for which they are responsible for.

The great rotation
So will 2013 will be the year of the “great rotation” out of government bonds and into equities? To many, it seems obvious that the long-term returns from government bonds will be dismal, in real and nominal terms, so stocks are the asset to get into. The relative valuation of equities looks good; the dividend yield in many markets is higher than government bond yields, something that was common in the first half of the twentieth century, but has been rare since.

There is an increasing belief, and it has to be said hope, that we have moved into a post-crisis era and policy makers will ultimately act to prevent systemic events from materialising. There have been false dawns before, but there are a few differences with the past two years.

Iain Stealey, portfolio manager, Global Multi-Sector Income Strategy at JP Morgan Asset Management, says: “Following a few strong final weeks of 2012, the positive momentum has continued for risk assets this year. Equities are up over 5 per cent. A sense of calm and optimism has descended over the markets.”

A view reinforced by Russ Koesterich, BlackRock’s chief investment strategist. “US equities are up around 4 per cent so far for the year, as are markets in Europe and much of Asia. Some of this can be attributed to temporary enthusiasm and seasonal strength and we do expect stocks to experience tougher going in February. That said, notes Koesterich: “A continuation of 2 per cent economic growth combined with low inflation is not a bad environment for stocks. Equity valuations remain reasonable (particularly outside the United States), so we would view any near-term volatility as a potential buying opportunity.”

Paul Causer, Invesco Perpetual’s chief investment officer, says this year, his focus is increasingly on equities. “We have now raised our equity exposure to 14 per cent. We think this could move considerably higher over coming years as banks return to profitability and distribute dividends.”

Andrew Wauchope CIO at UBS Wealth Management, supports this scenario: “It is our view that many of the key elements for an overweight position in equities are in place. Market momentum is supportive, long-term valuations are appealing and global growth dynamics are improving.”

Sentiment is also improving. “In December, for example, Intel sold $6bn in bonds to fund a buyback of its stock. This kind of corporate behaviour has led to equity market outperformance. US mutual funds took in more than $7.5bn in the first week of 2013, the largest weekly inflows in more than a decade,” says Wauchope.

In a world of low growth and low inflation, where central banks remain accommodative, the good times can roll. “But,” notes Stealey, “investors should be aware that this environment increases idiosyncratic risk and the need for active management and good issue selection becomes critical.”

Within this, Andrew Cole, member of the Multi-Asset Team at Baring Asset Management, says: “We expect sterling to continue weakening and this should provide a useful fillip to what remains undemanding earnings expectations for UK stocks exposed to the wider global economy.”

In another boost to growth prospects, the Basle committee on banking regulation announced an easing in the liquidity rules for banks. Regulators will now allow a greater range of assets in the liquid asset pool. Their action gained far less media attention than that of the US politicians, but will be equally important in supporting global growth by slowing the de-leveraging process of banks.

Reasons to be positive
Oliver Burns, an investment director on the Jupiter Private Client and Charities team, says there are a number of reasons to be positive. “The slow recovery from financial crisis – the financial world did not collapse although we might have come closer than we thought, stock markets tend to be forward looking and have now discounted a recovery of sorts. There is global growth – many regions of the world continue to grow strongly – many Western companies benefit from this – that is the FTSE 100 over 70 per cent earnings are now overseas.

On monetary policy, Burns says low interest rates and low bond yields are forcing investors to seek other sources of income. “Dividends in this context look attractive – the current dividend yield on the FTSEE 100 is 3.5 per cent compared to 2.1 per cent for the 10 Year Gilt, and inflation protection – real rates of return from cash and western government bonds are negative providing no protection from inflation – one of the consequences on unorthodox monetary policy could be higher inflation so investors are seeking asset classes that may provide some inflation protection. Equities do not provide a perfect inflation hedge, however, they tend to perform better than bonds.”

Burns concludes: “There does seem to be some evidence of investors returning to the stock market with UK equity unit trust sales rising strongly at the end of 2012 – albeit from low levels.”

Nigel Bolton, head of BlackRock European Equities, says that assuming that political momentum continues to accelerate, and that we avert the postponed fiscal cliff outcome in the US, 2013 will be positive, listing: global economic momentum; promising
structural reforms in Eurozone periphery countries gathering pace; supportive monetary policies across the world; attractive valuation levels for European equities both versus history, and versus other developed markets and versus other asset classes, and investor positioning that remains low in European equities.

Bolton adds that investors are slowly realising that their equity underweight position is no longer sensible. “We see potential total return for European equities of around 15 per cent in 2013. This assumes 9 per cent earnings per share growth, 4 per cent dividend and a small element of re-rating.”

Politically, things seem more stable. There is the view that politicians will ultimately do the right thing; even if it means exhausting all the alternatives. “For the Eurozone we still see a year of relative calm after the election year of 2012,” says Burns. The up-and-coming Italian election looks set to deliver a government which will continue the Monti
reforms and the focus will then be on Germany in September. In this scenario, the Greek crisis is taken out of the equation by the latest bail-out. But in the US, there is the possibility of another battle when the debt ceiling expires on May 19.

Ultimately the economic imperative of keeping growth and the economy going has brought politicians to the right decision. However markets, particularly equities, have played a role in this. Should we now enter a period of financial market complacency, the incentive for politicians to act and the prospect of a favourable outcome will be reduced.

So where to invest? Invesco Perpetual’s Adrian Bignell, says: “We are looking for companies that can grow organically above the rate of GDP. Secondly, we are looking at multinational growth stories. They are European listed companies that have large sales abroad: Nestlé has over 50 per cent of its sales in emerging markets and Unilever is the same. These companies can access international growth rates that are still attractive.

“Thirdly, we are looking for restructuring stories: companies that understand the macro is going to be tough, that top line growth is difficult to come by, and what they can do to improve earnings is restructure their cost base. The airlines are a really good example of this. Lufthansa has a cost cutting programme called Score.”

Note of caution
That said, there is a cautionary note, with Stealey observing the global outlook is far from thrilling. “Even with all this ultra accommodative policy from central banks, the developed world will not be returning to above trend growth anytime soon. The latest forecasts from the IMF agree as just last week they lowered 2013 growth expectations.”

In addition, the prevalent 2012 tail risks may have been contained for the time being but they have certainly not been resolved. With the US debt ceiling deadline extension, the market will soon focus on the Budget Control Act sequestrations.

And more fundamentally, according to recent work by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School looking into equity returns since 1900, a low real interest rate is also a lower return world for equities – they expect equities to generate a real return of 3-3.5 per cent over 20-30 years, according to the Credit Suisse Global Returns Yearbook 2013.

Their data also shows that global bonds have delivered a better return than equities since the start of 1980. That is a problem because of the assumptions many investors have made about equities.

Charities and endowments tend to spend 4 per cent of their portfolios each year; if their real return is only 3 per cent they will steadily deplete their spending power. “This creates a real challenge for charities, endowments and foundations who must assess the sustainable level of spending without destroying the long term value of any funds,” says Burns.

But as Tom Stevenson, an investment director at Fidelity Worldwide Investment, observes: “Bull markets do tend to start when people are trumpeting the death of an asset class.”

However, within the London Business School argument there are in fact a number of potential approaches to long term equity market valuation, such as trailing or forward Price Earning Ratios (P/E) or an adjusted ratio such as the Schiller P/E. Both can lead to “misleading” results. In the case of the former, equities are likely to look expensive in recessions and cheap when earnings are booming. In the case of the Schiller P/E it can miss entire regimes of over and under valuation.

“Equity valuations cannot therefore be viewed in isolation,” notes Wauchope. He adds: “Any effective model needs to take into account other long-term factors effecting valuations. Global growth dynamics are indeed good but, whilst sentiment is improving, sentiment remains relatively poor.

“Investors were clearly dismayed at stock markets failure to provide adequate risk adjusted returns over the last decade and the experience of equities producing annualised returns, that were nearly a fifth of those in bonds over the period, has re-enforced a fear of equity volatility.”

Sentiment will therefore continue to play a significant role in determining market levels and, until there is a “sea change” in sentiment, therefore under this reading the “Great Rotation” may have to wait until investors finally decide to invest on a reasonable valuation basis, given the risks they perceive.

Wauchope adds: “We believe investor sentiment is likely to remain cautious, until there are clearer signs of problems being solved, or investors are happier to take on greater risk. For this reason, we are happy to have an over-weight to equity but only as part of a diversified portfolio. We continue to believe that investors should diversify as widely as possible to ensure they can manage potential volatility in what are still difficult markets.”



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