Stocks are expensive. Bonds are expensive. What is an investor to do? Unfortunately, the only answer appears to be to invest in new and unfamiliar assets, taking new and unfamiliar risks.
Both equities and bonds look expensive compared with their own history (dramatically so in the case of bonds). Put the two together and the plight of pension funds with fixed liabilities to meet appears impossible. Cliff Asness, a former academic who now runs AQR Capital Management in New York, says the prospective return over the next decade from a portfolio invested 60 per cent in US equities and 40 per cent in bonds is 2.4 per cent per year. This is the worst predicted return in 112 years.
An alternative forecast by Elroy Dimson, Paul Marsh and Mike Staunton, financial historians at the London Business School, points to the extreme low real interest rates and shows that these have been associated over history with low subsequent returns for both equities and stocks.
They suggest that the returns in the late 20th century were driven by unrepeatable positive factors such as the postwar booms in Germany and Japan, and the fall of the iron curtain. Now, global demographics give institutions no room for manoeuvre. As the ‘baby boom’ cohort retires, the balance shifts from those contributing to pensions to those receiving payouts.
Further, the quantitative easing policy of the US Federal Reserve has kept bond yields down, in effect forcing savings groups to lend to the government at low rates, while making it more expensive for “defined-benefit” pensions, which have promised a set level of pension, to fund future liabilities.
As a result, a recent survey by the Create consultancy of more than 700 asset managers, managing $27.4 trillion between them, found that 78 per cent of defined-benefit plans would need annual returns of at least 5 per cent per year to meet their commitments, while 19 per cent required more than 8 per cent – far higher than reasonable projections.
One result is that fund managers are charging less for their services. Fees that were acceptable when returns were high now look unsightly. Also, institutions are firing “active” managers and moving money to cheaper “passive” managers who merely match market benchmarks.
“For every five active mandates that come up for renewal, three end up in passives or exchange traded funds,” said one fund manager interviewed by Create.
Institutions are also taking on more risk. According to Asness, a target of 5 per cent per year can be reached but only “by using the three dirty words of finance – leverage, shorting and derivatives”.
Laurence Wormald of Sungard, a London-based consultant, says: “People are faced with the reality of having to look beyond low-risk asset classes, which will have negative returns. This forces them into unconventional asset allocation.”
He warns that funds will have to change their risk management to strategies used by the trading desks of investment banks. They must factor in the chances of losses, look at “tail risks” of extreme events and at the risk that counterparties’ credit fails – all disciplines found wanting in 2008.
They are also looking at new asset classes. Hedge funds, which can use leverage and sell short, have enjoyed huge inflows from large institutions, increasing their assets by more than $500 billion, or almost a third, since their pre-crisis peak. They have done this despite very poor performance. Pension funds would have been better leaving their money in stocks – and are reassessing the move.
The most popular new asset class is property, named by 55 per cent of defined-benefit managers as part of their plan to close the gap with their pension promises, while 44 per cent said they were investing in “alternative credit”. This gained a bad name during the crisis and includes senior loans, collateralised loan obligations, subordinated corporate debt and commercial mortgages.
The retreat of banks from these markets, post-crisis, has added to the interest from fund managers, as these assets become available to them on more favourable terms. “Like real assets, alternative credit has one overriding virtue,” says Amin Rajan of Create. “[It has] low correlation with traditional equities and bonds, and high single-digit yields.”
There are dangers in moving beyond core competencies but pension funds know that if they stick with bonds and stocks they will probably fail to meet their promises.
The London Business School professors are emphatic that the old way is not an option. “To assume that savers can confidently expect large wealth increases from investing over the long term in the stock market – in essence, that the investment conditions of the 1990s will return – is delusional,” they say.
Bonds: Is the 30-year bull run over?
Treasury bonds have been in a bull market, with rising prices and therefore falling yields, for longer than almost any trader working today can remember. As the chart shows, 10-year Treasury bond yields peaked, at the now almost unimaginably high level of 15 per cent, in 1982.
Since then, the trend has been inexorably downward, with each peak in yields lower than the one that preceded it. The trend line marked on the chart is widely known and followed by bond traders. Bond yields remain far below it.
Bond prices cannot fall for much longer without nominal yields becoming negative – meaning that investors would in effect be paying the government to look after their money. Further, intervention by the Federal Reserve to buy bonds in an attempt to push down their yield, in a policy known as quantitative easing, is also believed to have distorted the market.
Bond yields have risen sharply in recent months, accompanying the “tapering” rhetoric from Ben Bernanke, the Fed chairman, and many believe that the trend has finally turned. To them, the bond bear market has finally started.
“There’s a lot of denial among bond managers,” Jim McCaughan, chief executive of Principal Global Investors, says. “They’ve had a 30-year bull market and they’re finding it very hard to let go of that because it’s covered their entire careers. They still don’t really believe that yields are rising.”
Ian Harnett, an analyst with Absolute Strategy Research, a consultancy in London, found the same phenomenon. “Have bond yields troughed? American clients weren’t prepared to say that they had. And when you asked when they troughed, nobody knew – July last year was the low point.”
Both suggest that rising bond yields are a healthy development because they show that the economy is returning to normal. The only concern would come if the bond market instead staged a “disorderly” retreat from low yields. If panicked bond trading pushed interest rates up sharply, this could have ugly knock-on effects for the economy.
For now, Harnett says that the Fed is trying to “boil markets alive” – gently getting markets accustomed to rising bond yields until they reach a point when they say: “That wasn’t bad, was it?”
However, there are arguments that bond yields could move still lower.
Albert Edwards, chief investment strategist at Société Générale and a famous bear on the equity market, suggests that markets and the economy are stuck in an Ice Age in which bond yields will grind lower. He points out that the downward trend in bond yields remains intact.
“Bond yields at 2.5 per cent still remain locked in a technically well-established bull trend that will not be broken until yields spike above 3.5 per cent, “ Edwards says.
He also points out that “amid the carnage in the government bond market, implied inflation not only remains subdued but has fallen decisively”. This is important because outright deflation is a good environment for bonds – it means that the buying power of coupon payments rises over time. “Maybe that reflects an acknowledgment that the economy is indeed nowhere near exit velocity. Deflation risks remain high.”
If Edwards and the bond bears are right, then economic growth will remain sluggish, prices will fall and other central banks will have to resort to further rounds of bond purchases – which would themselves help to push up bond prices. “QE 99 here we come,” he says.
If the path that the Fed appears to be tracing at the moment, with a steady exit from QE, proves accurate, then the bond bear market has, almost certainly, already started.
Equities: Just a bear market rally?
Are stocks in a bull or a bear market? Some think that it is ridiculous even to ask such a question. US stocks have more than doubled in four years. The S&P 500, the world’s most widely followed index, is at an all-time high, having passed the record it reached in October 2007.
In relation to bonds, equities look very cheap. The S&P yields 2.04 per cent in dividends, which until months ago was a higher yield than investors could get from the coupons on Treasury bonds. After decades in which dividend yields were far lower than bond yields, this appears cheap.
However, there are arguments that this is still a continuing secular bear market. Equities do not look cheap compared with their own history. First, the S&P, after accounting for US inflation, is almost 18 per cent below the level it reached in early 2000 as the internet bubble was bursting.
Second, long cycles of ‘bull’ and ‘bear’ markets are defined by how expensive stocks are at the outset. In a bear market, valuations steadily become cheaper until stocks are unambiguously attractive once more.
How to measure cheapness? Cyclically adjusted price/earnings (Cape) multiples, where share prices are compared with average earnings over the previous 10 years to account for changes in the business cycle, have been a good guide to long-run returns.
In 2000, when the bear market first broke out, the Cape on the S&P stood at 44, by far the highest in history. Even the Great Crash in 1929, which was followed by the Great Recession and a savage bear market, began with a Cape of only 32.5.
Now Cape stands at 23.5 – far above its historical average, although not at an extreme. Historically, as the chart shows, investors can expect equities to gain less than 1 per cent in a decade if they start with Cape at this kind of level. Generally, bull markets only start when it has hit single figures.
Ed Easterling, an expert in secular market trends at Crestmont Research in Oregon, says: “In 1996, we got to the normal high but then went into bubble mode. We’ve spent the last 13 years going from the bubble zone to the overpriced zone. We can’t start a secular bull market from here because we don’t have valuation levels low enough to give us above-average returns in future.”
Others are more optimistic but admit that the strange circumstances this time, with aggressive intervention from central banks following an extreme financial crisis, make judgments difficult.
“I think we are still in a secular bull market but it’s certainly different from normal,” says Andrew Milligan, head of asset allocation for Standard Life in Edinburgh. “Your standard secular bull market starts with a recession, central banks cut interest rates and investors pile back in when they realise things are picking up. This time it’s different because the recession was caused by a financial crisis, not an inflation shock, and we’ve had a QE response, not just an interest rate response.”
The interplay of equities with commodities is another reason for optimism. Commodity prices appear to have started a new downward trend. Historically, downward trends in commodities tend to overlap with bull markets for stocks.
“In our view, certainly the commodity supercycle is over, for metals and oil. But we are a little cautious to say that we’ve now entered a new secular bull market in equities,” says Harry Colvin of London-based consultancy Longview Economics.
“First, valuations never really got very low and second, we are still very heavily indebted.”
He adds: “We probably need one more shock. The eurozone crisis or another recession in the US or a Chinese hard landing could give us the final stage of the bear market and then we can go on to a secular bull market.”
Copyright the Financial Times 2013.