Ten more years

Now I could be talking about the number of years Boris will be in power or, equally worryingly, the number of years before England regain the Ashes. Actually, I’m talking about the shape of market returns over the decades. This is how the 2010s have panned out, with returns rebased to sterling for UK domiciled investors…

The aftermath of the great financial crisis, the Eurozone banking crisis, Greece, China growth shock, Brexit, Trump, trade wars….there has a cacophony of noise, a diva-load of drama, and plenty of reasons to be bearish, but when the smoke clears on the last decade there are some pretty obvious takeaways

  • It’s been a great decade for investment returns
  • Equities have returned above historic averages
  • Bonds have returned well above historic averages
  • Returns from the US have been double that of everywhere else
  • Japan hasn’t been a basket case 
  • Returns from Emerging Markets have been half that of everywhere else 
  • Returns from the UK have been pretty good despite the opposite perception 
  • Growth has hugely outperformed Value 
  • Inflation has been very muted
  • Returns from cash have been pitiful

Hidden in the numbers, and to an extent, the reasons for them, are some decade-long changes. 

  • Bond yields have fallen, fallen, fallen, fallen, fallen…and fallen again.
  • Nearly 25% of all government and corporate debt is trading with negative yields. 
  • The US is at multi-decade highs against the UK, European and Japanese markets. 
  • The UK equity valuation relative to that of the US hit its biggest discount in more than a century in 2019
  • Sterling hit a 34 year low against the dollar in 2019. For the decade as a whole though it was not as weak as perceived, being relatively flat against the euro and yen and only weakening 20% against the mighty US dollar, all in the second half of the decade. 
  • Passive funds account for 45% of total funds in the US equity market, up from 25% ten years ago.  
  • China’s debt to GDP ratio has risen from 150% to 300%.
  • The big ‘winners’ have been Technology funds, the big losers Commodity and Energy funds.

These trends have been going on for so long that investors have become de-sensitised to them and maybe now see them as a permanent state of affairs. If I had a pound for every time I’ve heard people say, ‘value investing is dead’ and ‘only ever buy growth stocks’ then I’d be able to buy out the entire share capital of Amazon lock, stock and (next day delivery) barrel. 

Now, look at the returns from the previous decade in comparison.

If I’d written this same piece back in 2010 I’d be telling you that 

  • It was a very poor decade for developed market equity returns 
  • The big winners were Emerging Market and Asian funds
  • The big losers were the US, Japan with negative returns 
  • Value (commodities) outperformed Growth (technology)
  • Bonds produced above-average returns
  • Inflation was very muted
  • Returns from Cash not too bad…until 2008

Two sore thumbs stick out

  • The most obvious point is the power of mean reversion in equity market returns. The noughties winners were the tens losers and vice/versa, look at the returns from the US in particular
  • What a lovely life it has been to be invested in bonds; all those returns with virtually no volatility as yields fell throughout both decades. Mean reversion in the bond market tends to be over multi-decade cycles, not single decades.  

The point is that the stock market is a discounting mechanism, Johnny-come-lately investors are not wrong in predicting what is going to happen, they just don’t make any money out of it. I talked earlier in the newsletter about markets climbing the ‘wall of worry’ when prospects look bleak and then sliding down the ‘slope of hope’ when the good news is already priced in. Investors who bought commodity funds in 2010 saying that China would be a massive buyer of commodities in the next decade were right, just that all this was already priced into the market before it actually happened. Similarly, investors bet the farm in the 1990s that technology would revolutionise our lives in the 2000s and hence the dot.com boom. It did, but investing in tech late 1990s/early 2000s got you carried out in the dot.com bust. 

A couple of points to further ponder; despite inflation falling throughout both decades linkers did far better than conventional Gilts, which appears counter-intuitive but is because linkers have a much longer duration and therefore benefit more when bond yields fall. Secondly, bricks and mortar commercial property funds did pretty well in both decades, their lack of leverage preventing total disaster in 2008. Be a little careful here, property is often ‘sold’ as an uncorrelated asset but it is a beneficiary of falling interest rates so a sharp reversal in bond markets would likely have an adverse reaction on this asset class too. 

I always say that being a contrarian for a reason is an excellent strategy as long as there is an investment case and a potential catalyst, but being a contrarian just for the sake of it is being an idiot. The biggest ‘contrarian’ calls facing investors are:

  • Is the bull market in Bonds finally over?
  • Is the relative underperformance of UK equities (and sterling) over the last three years going to continue?
  • Will growth continue to outperform value?

The bubble in bonds has been discussed a million times over, 999,999 times by me alone! My sense (a less confident way of saying ‘my view’) is that the collapse in bond yields this summer was a last hurrah but that yields will trade in a narrow range for the next few years to come, though with the direction of travel gradually upwards. Thus, a long, slow normalisation with the coupon from the bond offsetting any fall in yield. So there is an investment case for saying the bull market in bonds is over, but no catalyst for an abrupt reversal. 

The underperformance of the cheap UK market and sterling versus the outperformance of the expensive US market and US dollar is a more interesting contrarian play in that it has an investment case based on valuation and a catalyst, now triggered,  based on the new Tory government. Similarly, the decade laggard Emerging Markets have both an investment case (valuation and economic/earnings prospects) and a catalyst (resolution of trade wars). 

As with forecasting market trends and returns over the next decade, forecasting the economic fundamentals is an equally big ask but our friends at Schroders have kindly had a go and come up with what they see as the major macro trends:

  • Global labour force will decline
  • Poor productivity growth
  • Ageing population
  • Slower annual global growth
  • China retrenches its debt mountain
  • Inflation will stay muted
  • Interest rates to stay low

From this, they derived the following investment assumptions

  • Expect a slow normalisation of monetary policy to 0.5% above inflation so lower rates than pre-2008 but higher than today
  • Thus, no more multiple expansion, no more QE, no more ‘Fed put’ and more focus on earnings as a driver of markets
  • Lower market returns from all asset classes
  • Technological disruption, displacement of jobs, increasing focus on ESG
  • Political risk will continue to be a significant part of the investment landscape. Lower growth leads to lower tax revenue and higher spending on welfare whilst ageing populations increase the demands on healthcare and higher pension spending. Countries with poor public finances and poor demographics will be in trouble 
  • Populism will rise with de-globalisation set to continue. Expect long-running trade wars and more restrictions on immigration and capital flows.

So there you have it. Let’s have a look again in January 2030 at how well these predictions stand up.

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