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The post GFC investment environment.
What can history tell us?
A paper that puts the difficult post GFC investment environment into a
historical context and highlights investment strategies that can be
appropriate.
September 2010
Michael Karagianis
Investment Strategist
For Adviser Use Only
Andrew Connors
Investment Specialist
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MLC MARKET INSIGHT
09/2010
MLC Investment Management
Management
MLC Investment
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Table of Contents
Table of Contents ..................................................................................................... 3
Summary ................................................................................................................... 4
Part A - History Doesn’t Repeat, But it Does Rhyme .............................................. 5
Great Depressions................................................................................. 6
Part B - Lessons From History ................................................................................. 10
The importance of crisis response........................................................ 11
Example - Sweden a shining light ....................................................... 12
US – a Swedish or Japanese workout? ................................................. 13
Part C - Investment markets and banking crises ................................................ 15
Part D – Where to from here? ................................................................................ 20
1. Investing for a “V” shaped Recovery ............................................. 20
2. Investing for Deflation.................................................................. 21
3. Investing for the “muddle through” scenario ................................ 22
a) Dividend Yield vs Capital Gains ................................................... 23
b) After-Tax focus ............................................................................ 25
c) Dollar Cost Averaging .................................................................. 25
d) Diversification ............................................................................ 26
e) Active Management vs Passive Management ................................ 28
f) Absolute Return strategies vs Benchmark Relative investing ........ 29
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Summary
If you ignore history then you’re doomed to make the same mistakes.
The current uncertainty in the global economy is going to be around for a while.
This will likely result in greater ongoing financial volatility coupled with more
modest investment returns. Risky markets such as equities may be in a
consolidation trend for an extended period of time. Whilst this presents
challenges, as investors there are strategies which can be pursued which can
still seek to deliver returns in such an environment. These include:
1.
2.
3.
4.
Diversification
Dollar cost averaging
Active management
Risk aware strategies that focus on the absolute return potential offered
by high quality investments
5. Secure and stable income returns from high quality assets including
equities
This paper serves to improve awareness that the current market environment,
whilst unusual based on positive experience of the past 15 years in Australia, is
not unique and that with appropriate investment strategies investors can
successfully navigate this period.
The MLC Horizon portfolios:







Are diversified across 14 asset classes and sub asset classes including
overseas investment exposure;
Include Alternative and Absolute Return strategies such as Insurance
Related Investments and multi sector managers;
Are actively managed using some of the best available managers from
around the world;
Are priced daily meaning your funds are available whenever you want
them;
Are backed by MLC, a highly respected investment manager;
Have a good long term track record;
Are robustly tested using sophisticated scenario analysis.
If you would like to discuss the paper further, please call any of our investment
specialists listed below.
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Andrew Connors (02) 9376 5377
4590
Natalie Comino (02) 9936 4538
9936 4537
Marius Wentzel (02) 9376 4549
John Owen
(02) 9936
Kajanga Kalatunga (02)
Or email us at mlc_investments@mlc.com.au
Part A - History Doesn’t Repeat, But it Does Rhyme
The recent bout of financial market nervousness serves as a timely reminder to
investors of the unusual nature of the challenges facing the global economy and
hence investors, in the current cycle. Renewed declines in equity markets of
between 10 and 15% from their April 2010 peak to late August 2010 reflect a
broader escalation of concern about the next stage of the global economy, as it
slowly crawls its way out of the hole left by the Global Financial Crisis (GFC).
Whilst the GFC has in many ways been compared to the Great Depression, at
least thus far, it is yet to resemble the magnitude of economic disaster
represented by the Great Depression. To put it into context, US GDP growth fell
peak to trough by just under 5% through the GFC whilst the Great Depression
experienced a peak to trough decline in excess of 25%. Nonetheless, the impact
of the GFC on the US and global economies has been particularly severe as has
the impact on investor returns. This paper seeks to look at the history of
financial and economic crises to ascertain what lessons they may hold for
investors in the difficult post-GFC environment.
Peak to trough decline in US GDP – GFC vs Great Depression
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Great Depressions
We refer above to the challenging environment produced by the GFC as
“unusual” rather than unprecedented, because even a casual look through
history shows a surprisingly regular occurrence of similar such crises over the
past 100 years or so. Given the wealth of financial crises through history, it
could be useful to assess how these crises evolved to get a sense of prospects for
the current environment. It is particularly useful to contrast the experience of
crises through history to identify factors that were key in determining the
severity, duration and ultimate outcome of these events.
Whilst it is possible to go back as far as the Great Tulip Bubble in 1637
Amsterdam and the South Sea Bubble of 1720 to observe early recorded asset
bubbles or mania, we can start the story more recently. A major asset bubble
and subsequent banking bust was associated with The Depression of 1893. It
afflicted the US economy and followed the great railroad construction bubble of
the preceding 10-15 years which saw the creation of an enormous railway
network across the US, in the process creating huge speculative wealth.
The bursting of this bubble created a Depression lasting more than 6 years
where the unemployment rate was thought to have hovered between 10 and
19%, albeit that there were no reliable statistics at that time. Hundreds of
banks, having extended railway construction loans, failed through this period as
railroad companies defaulted on their debt. Rural and regional property prices,
having been over-inflated by the railway boom, collapsed spreading the impact
to the household sector. It wasn’t until 1899 that the crisis ended and conditions
returned to something approaching normal.
Curiously, Australia suffered its own Depression, independent of the US
experience, at that same time, based on similar railway debt and declining wool
incomes.
Only 30 years after the ending of one Depression, the Great Depression of the
1930’s is viewed as the first true global Depression having been triggered by the
cataclysmic aftermath of the October 29, 1929 stock market crash.
The
measured unemployment rate in the US rose to around 25% at its peak in 1932
and remained elevated above 10% for more than a decade. In fact it wasn’t until
World War 2 that the US economy saw unemployment levels fall to preDepression levels.
The Great Depression was felt globally. Virtually every country was impacted by
the collapse in world trade to somewhere between 1/3 and 1/2 of its preDepression levels. Australia was one of the most severely affected countries
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with the unemployment rate reaching 28% in 1932. In fact it averaged above
20% for the first half of the decade and was above 10% at the outbreak of World
War 2. Australia’s traumatic experience during the Depression was only
exceeded amongst industrialised economies by Germany’s, where the
unemployment rate peaked around 30% ahead of the election of the National
Socialist Party in 1933.
The specific triggers for the onset of these two major Depressions were very
similar as was the evolution of the crises. In each case the key was a significant
bubble in financial assets and property, funded by excessive debt provided by
the banking sector. As a consequence of the subsequent collapse in asset prices
and the exposure of banks to those assets, in each case there was a widespread
systemic collapse of the banking system as bank capital was destroyed and
depositor wealth wiped out.
In the case of the Great Depression approximately 9,000 banks failed in the US
alone through the 1930’s.
Without depositor insurance or government
compensation at that time, individuals saw their life savings wiped out. By way
of comparison, post GFC, the period 2008 to 2010 has seen approximately 274
banks fail in the US, although depositors are largely covered by Federal deposit
insurance.
Viewing these major Depressions together it is possible to identify essential
ingredients which can turn a common run of the mill asset bubble, bust and
resulting recession into worst case
Depression. It the case of the two Depressions mentioned it was the magnitude
of banks exposure to the particular asset bubble and the devastation the
resulting bust inflicted on the banking sector.
In these pre-World War 2 occurrences, the evidence suggests that the impact of
asset busts on banks was particularly severe, with widespread insolvency of
banks leading to a loss of lending activity in an economy and widespread
destruction of wealth. Importantly, in each case the Government of the day was
unable or unwilling to undertake the necessary steps to prevent the cataclysm
from enveloping the broader financial system and economy.
Deflation not inflation reigned supreme through these periods and individuals
and companies were unable to spend or invest because of financial stress and
widespread fear. Once deflation expectations became embedded it became very
difficult to produce an economic recovery because the belief that activity and
prices would continue to fall in future acted as a powerful disincentive to
consume or invest now.
The key focus for investors during these difficult economic periods was not a
return on capital but rather a focus on capital preservation. Given the parlous
state of banks at the time, capital preservation was often achieved by keeping
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money “under the bed”, hoarding gold or, by investing in government bonds,
although the latter approach failed in certain countries where political collapse
resulted in a failure of countries to repay debts. The returns provided from
equities were weak or negative for very long periods of time – in the case of the
Great Depression about two decades.
Up until the Global Financial Crisis (GFC) of 2008/09, as investors we haven’t
really thought too much about these previous periods of history, their relevance
considered only by economic and investment historians. The belief in a more
sophisticated global economy and financial system and greater confidence in the
management of them had led to widespread complacency and an ignorance of
many of the lessons from these extraordinary periods.
These lessons are important to understand however, as it is clear that, far from
being infrequent in the modern age, asset bubbles, busts and associated banking
crises have been, if anything, even more common in the past 20-30 years. The
IMF in fact has identified 124 systemic banking crises in the period from 1970 to
2007, of which 42 are well documented occurring in 37 different countries.
Despite this, the experience and lessons of such crises are generally very poorly
understood or appreciated.
In part this may be because these crises have often occurred in smaller, more
isolated cases than we are seeing with the GFC (eg. Spain 1977, Sweden 1991,
Finland 1991). Or they have occurred in emerging economies (eg. Latin America
Debt Crisis through the 1970’s and 1980’s, Mexican Peso Crisis 1994, Russian
Default Crisis 1998 and, the Asian Financial Crisis 1998), where their relevance
for developed economies is considered minor.
However, we have seen asset bubbles and associated banking crises hit closer to
home in major developed economies in recent history (eg. US Saving & Loans
Crisis 1988, UK 1992, Japan 1997). Of these, undoubtedly the most severe has
been the great Japanese Deflation which commenced in 1990, leading to a
banking crisis in 1997. This Japanese experience, whilst different in many ways
to the work-out of the Great Depression, nonetheless has a similar asset bubble
foundation and is proving just as enduring, continuing to this day.
GFC impact on US housing and bank activity
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In each of the cases above, excess debt helped to create a major asset bubble,
generally in property markets, which ultimately burst, undermining or
rendering insolvent large portions of the banking sector of the country in
question. The GFC has had a similarly dramatically negative impact on US
residential property prices and the US banking sector over the past two years
and is shown above.
Whilst then, the GFC is simply the latest such crisis to hit, it is perhaps the most
dramatic financial and economic crisis of the post War period by virtue of its
widespread impact on major developed economies, their property markets and,
most importantly, their banking sectors.
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Part B - Lessons From History
What lessons can be drawn from the recurrence of banking crises through
history that may assist our understanding of the post GFC environment?
The most fundamental are that the impact and duration of the crisis on an
economy and the financial sector is largely a function of three factors;
1. How severe the asset bubble was – the more severe the asset bubble
potentially the more dramatic and enduring the impact of its collapse
on the economy and financial sector.
2. How significantly affected is the banking sector by the asset bust - this
is a function of how involved the banks were in funding the asset
bubble through the provision of debt and their subsequent exposure to
collapsing asset values. Property deflation tends to have a dramatic
impact on banking sectors because of their traditional role as
providers of mortgage debt financing.
3. How aggressive and ultimately successful the remedial actions by
Governments are to stabilise and rebuild the banking sector post crisis
- the more aggressive the remedial action the greater the potential for
a recovery in economic activity and asset prices over a short time
frame.
In general, the more over-inflated the asset bubble and, the more exposed the
banking sector is to that bubble, the worse the ensuing crises and its impact on
the affected economy and financial sector.
Using this rule of thumb, the GFC ranks highly on the scale of crisis. Being
centred on the residential property market in major developed economies such
as the US and UK, the bubble and subsequent bust has produced a tremendous
negative wealth shock for an enormous number of people. This impact far
exceeds the impact of the TMT crisis in 2000, which was largely a corporate
debt problem for capital markets with relatively modest exposure on the part of
banks and households. The impact of the GFC on the banking system of many
countries has been disastrous with a number of banks failing or requiring
emergency support to avoid collapse, in the aftermath.
It would therefore be reasonable to assume that the nature of the GFC ranks this
event amongst the top tier of banking crisis going back to the Depressions of the
1890’s and 1930’s or the Japanese Deflation of the 1990’s, with the potential to
be as severe and durable in its impact on economies. However, is there anything
that gives us more comfort that the work-out of the global banking system,
economy and financial markets post-GFC will be less severe and more rapid than
history suggests?
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US Bond Market pointing to risk of deflation post GFC
US 10 Year Treasury Bellweather
5.5
5
Boom / Inflation alert
4.5
4
3.5
3
Recession / Deflation alert
2.5
2
12-Jul-05
12-Jul-06
12-Jul-07
12-Jul-08
12-Jul-09
12-Jul-10
Source: Datastream
The importance of crisis response
Whilst the nature of the asset price collapse and the exposure of the banking
sector to that collapse are important determinants of the nature of banking
crises, the third factor listed above can have a major influence on the ultimate
workout of an economy and its financial system following a banking crisis. That
is, the nature and rapidity of response by political and monetary authorities to
address and correct the problems in the financial and banking sectors, can have
a major impact on the severity of the crisis and period required to return to
normalcy. In this regard, the lessons of history are quite stark.
The magnitude and durability of the Great Depression and the Japanese
Deflation can both be traced directly to abject policy failure at the time the
crises began to unfold and in the years immediately following.
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In the case of the Great Depression, following the onset of the crisis in the early
1930’s, the initial response by authorities globally was to leave interest rates
virtually unchanged and to actually introduce fiscal austerity measures.
The crucial role of central banks in being able to provide emergency liquidity to
the financial sector, and banks in particular, was not well understood, nor was
the extreme panic that could be generated by a severe banking crisis. As
liquidity dried up, banks were unable to meet their obligations as depositors
queued outside their doors to withdraw savings. The failure of the
monetary authorities to understand and meet this threat allowed the banking
system to effectively collapse.
Similarly, a misunderstanding or philosophical disagreement as to the role of
government and fiscal spending in a recession environment, saw governments
move to actually tighten fiscal conditions through the early years of the crisis,
through cuts in public spending. The aim was to stabilise government deficits
and debt levels. The result was to produce a savage Depression as both public
and private sector activity collapsed. It was not until the Roosevelt New Deal in
1933 that the US saw this policy reverse. By then the Depression was at its most
intense.
Inappropriate monetary and fiscal action (or inaction) by governments and
authorities globally in the early 1930’s turned a recession into a decade long
deflationary Depression.
Similarly, the failure of the Japanese authorities in the early 1990’s to move
rapidly enough to introduce aggressive monetary and fiscal stimulus, allowed
deflation to take hold in the economy. The crucial failure to move aggressively
to recapitalize the banks affected by collapsing property prices and to remove
bad debts from their balance sheets, ensured a prolonged deflationary slump,
culminating in a banking crisis in 1997. The Japanese economy continues to feel
the effects of these policy failures to this day with deflationary pressure still
dominant.
Whilst these are notable examples of policy failure in the midst of banking crises
which allowed deflation to take hold in the US and Japan, there are equally,
examples of where countries, presented with a severe banking crisis, have
moved quickly to introduce aggressive restructuring to their banking sectors
with excellent results.
Example - Sweden a shining light
The response of the Swedish authorities in the early 1990’s, to the severe
banking crisis which gripped the Swedish economy is such a shining light. A
dramatic property and equity market bubble developed in Sweden in the late
1980’s funded significantly by excessive bank credit. This bubble collapsed in
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1990 creating a strong deflationary wave that engulfed the economy. The fallout for the banking sector was severe. Five of the six largest banks, accounting
for 70% of banking system assets, experienced solvency problems. Two banks
became insolvent.
GDP contracted by approximately 4-5% through to 1993. The government
response was to introduce an aggressive restructuring of the banks which
included the removal of bad loans from bank balance sheets to be placed in a
publicly funded resolution trust.
Banks were recapitalised, in some cases
merged or placed into public ownership for a period, with new management.
Depositors were protected but equity owners of the affected banks were wipedout by the restructuring.
Once complete, the restructuring of the banking sector allowed a robust
expansion in economic activity to commence in 1994 which continued virtually
uninterrupted until 2007.
This represents a text book example of aggressive and positive action by a
government within a relatively short timeframe once a banking crisis emerged.
The success of this approach shows that by applying the right policies quickly,
not only can a banking crisis be halted but a recovery
can be achieved within a reasonably short time frame, albeit not without
experiencing a period of severe economic conditions nonetheless, as was the
case in Sweden.
The question when assessing the prospects for the US and indeed the global
economy post GFC is whether efforts to respond to the banking crisis thus far
are closer to the Japanese or Swedish experiences?
US – a Swedish or Japanese workout?
Given that background, it remains uncertain as to whether the US has
introduced sufficient policy measures as yet to both avert the deflationary risk
and to revitalise its banking sector post GFC. It seems likely that enough has
been done to avert a “worst case” Great Depression or Japanese Deflation
outcome. However, it is far from clear that enough has been accomplished to
achieve a Swedish “best case” workout.
Certainly monetary policy remains a positive stimulant to the US economy with
both extremely low interest rates and quantitative liquidity injections at work.
The US Federal Reserve reacted to the GFC aggressively and was effectively able
to halt the spread of systemic problems through the US banking sector though
late 2008 and 2009.
The decline in key interest rates was useful in easing the scarcity of liquidity
that had emerged during the GFC. More significant however, was the volume
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supply of money into the financial system as the crisis deepened. This is
referred to as quantitative easing (QE) and essentially involved the Fed flooding
the banking system with large volumes of cash to meet the emergency
requirements of banks. As the crisis has eased so has the demand for emergency
liquidity via QE.
However, with the economy still fragile and interest rates
effectively stuck near zero percent, the Fed may well be called upon to do more
QE to reinforce those efforts over coming months. The problems within the
banking system however, make it far from certain that much of the Fed’s good
work is actually being felt within the wider economy at this time. This lack of
economic response to stimulative monetary policy settings following a banking
crisis, is a common observation and is classically referred to as “pushing on a
string”. History tells us that monetary policy alone cannot achieve an economic
recovery following a severe banking crisis.
Fiscal policy has also been a positive factor for the US economy and other
affected economies, in the wake of the GFC with significant stimulus
implemented through tax cuts and spending programmes, supporting
employment and growth over the past 18 months. However, we now see these
effects starting to wane as that spending runs its course and is not being
replaced by new programmes. Instead of a focus on continued stimulus to
maintain economic momentum, the new concern seems to be on the rise in state
and federal deficits and escalating government debt. This is a misplaced
concern which, if allowed to hold sway, heightens the risk of pushing the US and
other affected economies back into recession.
Whilst rising government debt levels are ultimately a concern to be addressed,
that is best done by re-invigorating economic growth. A strongly growing
economy will produce a natural tendency, given longer term prudent fiscal
management, to allow government debt ratios to decline over time. A premature
introduction of fiscal consolidation or austerity measures through the fragile
early stages of a recovery in the US and other major developed economies,
before the private sector has had the opportunity to recover, seems dangerously
similar to the
fiscal mistakes made during the first years of the Great Depression.
perversely cause debt ratios to widen even further as growth fails.
It may
Again, as with monetary policy, easy fiscal policy, whilst important in bolstering
an economy through the difficult post-crisis environment, is not sufficient of
itself to produce a robust
recovery. As observed in Japan through the 1990’s, massive fiscal spending over
the decade did not produce a substantial nor sustained economic recovery.
Something was missing from the policy mix.
A successful policy recipe following a major banking crisis requires that
supportive monetary and fiscal policy be followed by rapid and dramatic
restructuring of the banking system. This should be aimed at removing the
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source of the banking problems, namely bad debts and poor asset quality, from
bank balance sheets.
In regard to this last and most crucial element of policy response, the situation
in the US remains unclear.
The initial emergency measures to prevent
widespread bank system collapse have helped to stabilise conditions in the US
banking system thus far. However, the failure to remove bad loans from bank
balance sheets, as we saw successfully undertaken in Sweden, could see banks
struggle to recover for a long period as they continue to deal with escalating
loan defaults and declining property values. At present what appears to be
unfolding is a political unwillingness to tackle the problems head-on. This is a
major concern suggesting the potential for a “muddle through” work out over a
longer period rather than the quick recovery hoped for.
Stagnation is a real threat if positive action is not forthcoming. The evidence of
previous crises suggests that no country has effectively recovered from a
banking crisis until such time as the issues confronting the banking system were
effectively dealt with.
As investors, we must make a decision as to how we see this post GFC
environment unfolding; the Japanese style prolonged deflation, the Swedish
restructured rebound or, a sluggish “muddle through” middle ground scenario.
Based on the developments discussed above, the latter seems to be most
probable at this point.
Part C - Investment markets and banking crises
The difficulties which can face investors in the aftermath of a banking crisis are
highlighted by the observed performance of equity markets following such
events through history.
In the case of the Great Depression, the US Dow Jones collapsed by a spectacular
90% in the period from its 1929 peak to the height of the Depression in 1932/33.
It then bounced sharply, almost quadrupling from its lows over the following 4
years. This still left it some 50% below its peak however. For the next two
decades the US share market essentially tracked sideways. It wasn’t until 1954
that it moved above its 1929 peak, some 25 years having elapsed.
A unique observation? The performance of Japanese stock market index is even
more salutary.
Having peaked in December 1989 and, notwithstanding
occasional periods of appreciation since then, it has continued to deflate, having
fallen in the intervening 21 years to a value now
less than 25% of its 1989 peak. Whilst perhaps not as spectacular in its
deflation, it has been a more persistent deflation trend than observed during the
Great Depression.
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Both cases show how enduringly negative the bursting of a major asset bubble
can be on investment returns when associated with a major unresolved banking
crisis and long term deflation.
A poor policy response to a banking crisis can create
long term asset price deflation
(The Great Depression & The Great Japanese Deflation)
There are other examples, however, of banking crises associated with periods of
asset deflation where in fact, asset markets recovered within a shorter time
frame. In general, these cases were notable for either a less severe crisis or
more successful efforts to resolve the banking crisis.
In Australia’s case, with the 1991/92 recession, positive action to restore
banking sector stability and undertake recapitalisation resulted in a relatively
quick bounce back in asset prices, albeit still much longer than traditionally
observed following “normal” recessions. Having peaked in 1987, the Australian
All Ordinaries Index recovered to exceed that previous high a mere 10 years
later in 1997 although it briefly touched that level in 1994. For the intervening
10 years the market was effectively in a consolidation phase, see chart below.
In the UK’s case the early 1990’s recession produced dramatic property price
deflation. In aggregate, housing prices fell by approximately 20% nationally
between 1990 and 1993, similar
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in scale to that experienced through the GFC. The banking sector experienced a
significant crisis, particularly amongst smaller banks with 25 failing or closing
through this period.
Notwithstanding that, the FTSE 100 index was trading well above its 1987 precrash peak by the end of 1993. A major differentiating factor was that the scale
of the 1987 stock market crash was far less dramatic than experienced in
Australia with a decline of only around 35% compared with 50% in Australia.
During the Asian Financial Crisis (1997/98) Thailand, being the epicentre of the
crisis, was one of the worst affected countries. It suffered severe property price
deflation and bank solvency problems which kept the economy in a severe
recession for 2-3 years. Forced restructuring by the IMF however, caused
Thailand to resolve its banking crisis relatively quickly, allowing the banks to
recommence lending within about 4 years. In response the Bangkok Stock Index
ultimately exceeded the pre-crisis highs again, but about 10 years after the
event. This period might well have been shorter but for the intervention of the
global TMT crisis in mid 2000, which hurt many Asian technology exporter
countries.
Interestingly, whilst Hong Kong banks were relatively well protected from the
crisis, the Hang Seng Index took around 9 years to appreciate through its preAsian crisis highs although it did briefly breach those levels in 2000 ahead of
the onset of the TMT crisis.
Australian equities didn’t appreciate beyond the 1987 peak until 1997
One of the most positive stories of an equity market recovery following a
banking crisis was again in the case of Sweden. Having appreciated by 170% in
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the two years prior to its peak in mid 1990, the Swedish market subsequently
dropped 40% from that peak in the first 6 months of the crisis through early
1991. It then rallied sharply before losing ground once again in the second year
of the crisis.
The ultimate impact of positive policies introduced at this time was dramatic
however, with the Swedish stock index appreciating steadily from 1993
onwards. From its low point the index experienced a 500% appreciation over
the 5 years to 1997.
This was assisted by a general global economic recovery underway at that time,
but the performance of the Swedish equity market was exceptional compared
with most other countries at the time – by way of comparison, the Australian All
Ordinaries slightly more than doubled over the same period.
Based on the history of banking crises and their observed impact on economies
and financial markets, a major consideration for investors is to determine
whether suitable and aggressive policies have been introduced to avert
deflationary pressures and to restore the ability of banks to commence their
normal activities within an economy.
If that process has been successful and rapid then investing in equities and other
risk assets can produce dramatically positive returns. A failure however, to
introduce sufficient or correct policies can, at worst lead to multi-decade asset
price deflation and, at best see investment markets stagnating.
Will the US equity market follow the Swedish or Japanese post crisis
experience?
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MLC MARKET INSIGHT
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Equity market behaviour following banking crises
180
Pre-crisis peak = 100
160
Sweden (market peak July 1990)
US (market peak October 2007)
Japan (market peak December 1989)
140
120
100
80
?
60
40
20
0
52
104
156
208
260
weeks since pre-crisis market peak
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MLC MARKET INSIGHT
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Part D – Where to from here?
The next section outlines three potential market outcomes and details
investment strategies that may be appropriate.
1. Investing for a “V” shaped Recovery
The investment consequences of a “V” shaped recovery scenario where economic
growth recovers much more strongly than expected over the next 2-3 years is
self evident. It is an environment which would favour significant risk taking
within investment portfolios.
If you believe in this as the most probable outcome post-GFC then the best
approach to profit from this would be to increase allocations to traditional risk
assets such as equities and corporate / high yield credit dramatically.
Ultimately this scenario would be conditioned by rising inflationary concerns
and higher interest rates. However, it would not be unreasonable to expect 2025% p.a. average returns from risk assets over the next 2-3 years in an
environment of strong earnings growth and rising market multiples.
A “V” shaped recovery could see markets regain 2007 highs in the next
2-3 years
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MLC MARKET INSIGHT
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2. Investing for Deflation
At the other extreme, if you believe in the worst case “deflation” scenario then
once again it is a relatively straight forward exercise, given there are only a few
investment options available:
a) Cash – not for return but for capital preservation and liquidity
purposes.
“Under the bed” or invested with a high quality
institution, preferably Government guaranteed.
b) Precious metals – Gold is always a good store of value during crisis
times including deflationary periods. It is particularly attractive
because it provides some security against the debasement of the
currency that inevitably occurs when central banks start printing
money to counter deflation.
c) Absolute return strategies – have the ability to invest short and hence
can take advantage of environments where asset values continue to
fall.
d) Government bonds – again for capital preservation not return on
capital. At least you have security of the government being able to
print money to pay its debts. Make sure it’s high quality investment
grade government debt. A number of poorer quality governments
may struggle to repay their debts in a deflationary environment.
e) Capital protected / guaranteed strategies – aim to remove capital risk
if held until maturity. However, you are exposed to the credit quality
of the guarantor so make sure that it’s guaranteed or protected by a
highly rated entity.
Many of these deflation strategies are about trying to maintain capital value and
liquidity of investment. Returns would be a secondary concern in a deflationary
environment.
Investment in risk assets such as equities, property or credit should be avoided
as these are the most exposed asset classes under classic deflationary
conditions.
Gold already pricing heightened deflationary fears
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3. Investing for the “muddle through” scenario
In our view the “muddle through” scenario is the one that seems most probable,
at least for the next 2 -3 years. Under this scenario, risk assets such as equities
struggle to appreciate above the 2007 highs for a much longer period. Sluggish
global economic growth and the low disinflationary environment (but not
outright deflation) allow for modest market appreciation within the context of a
consolidation phase in equity markets (see chart below). The US has been in
such a consolidation phase since the peak of the Technology Bubble in 2000,
failing to appreciate through those market peaks.
The Australian equity market having seen the end of a major bull market in 2007
could similarly take an extended period to appreciate back to those previous
highs, if it has indeed entered such a consolidation phase. This has been
observed regularly in the past in the context of the Australian market, most
recently following the 1987 stock market crash, and earlier following the 1974
market correction. Both occasions saw a long period elapse before the market
regained and exceeded its highs.
US Equities in a 10 year consolidation phase
Could Australia experience the same?
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Nonetheless, this scenario suggests that risky assets can still provide reasonable
returns but they should be used with a more cautious view of the overall level of
risk incorporated within a portfolio.
Strategies that seek to achieve a reasonable level of return with a perhaps more
moderate or efficient exposure to high quality risky assets could be employed.
Some suggested investment strategies for the “muddle through” scenario are as
follows:
a) Dividend Yield vs Capital Gains
In periods of protracted market uncertainty and consolidation, as we may now
be observing post GFC, consistent and reliable market capital gains can be
harder to achieve.
The strong bullish market environment of the past 15 years, with above normal
returns from risk assets such as Australian equities, has enamoured us to the
idea of capital gains from the price appreciation of risky assets as the primary
source of investment return. This is the period where the “cult of the equity
investment” has taken hold in the mindset of investors.
This mindset
unfortunately led many relatively conservative investors to hold inordinately
large exposures to risky assets at the time the GFC hit.
This capital gains mantra will be challenged in a “muddle through” environment.
It may be that the attitude to equities needs to evolve back to an earlier period
when capital gains were not necessarily the most important driver of equity
investment.
By way of explanation, if you look back over a much longer time frame than the
past 15 years, it is evident that returns derived from capital gains on equity
holdings comprised a much lower component of the overall equity return, than
we have seen over this more recent period.
Contribution of Dividends to Total Return
S&P 500 Index since 1935
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MLC MARKET INSIGHT
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TOTAL RETURN
DIVIDENDS AS A %
OF TOTAL RETURN
1930's*
10%
N/A
1940's
144%
76%
1950's
466%
45%
1960's
110%
51%
1970's
75%
77%
1980's
389%
42%
1990's
423%
25%
2000's
-9%
N/A
201%
53%
Average
Source: Bloomberg and MLC
Over a very long period it is in fact dividend returns on equity investments that
have been at least as important a contributor to aggregate returns from equities.
Significantly, when we compare various periods through history, it is also
evident than the returns from dividends have been relatively more stable and
reliable than have capital gains, particularly during periods of relatively poor
economic activity and overall market performance. This is shown below.
Consistency of Dividends Returns
Annual price and dividend returns since 1980
65.0%
45.0%
25.0%
5.0%
-15.0%
-35.0%
Price Return
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
-55.0%
Dividend Return
Looking forward, if share markets have entered a “muddle through”
consolidation phase, where capital gains are less predictable or stable, then it
appears likely based on history, that the more reliable and predictable returns
provided by dividends on equities and other income generating
investments, will once again become a much more significant and more valued
source of portfolio performance. This is not a radical viewpoint – it is simply
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MLC MARKET INSIGHT
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turning the clock back to an earlier period where this investment reality
persisted.
This shifting return focus may have only a relatively small impact on the desire
to hold equity investments with the average investor’s portfolio. However, the
nature and composition of that equity portfolio may change markedly as
investors look for different attributes within their equity portfolios.
b) After-Tax focus
The management of investment portfolios for tax effectiveness may also come
under scrutiny in a post GFC “muddle through” environment. Seeking to
maximise after tax returns as opposed to pre-tax returns may be viewed as more
desirable in an environment where total returns are lower and less certain. This
may be observed in the form of more complex and specialised products designed
to heighten tax effectiveness for different classes of investors or, as basic and
simple as focussing on lower turn-over strategies, designed to reduce tax
realisation within portfolios.
An increased focus on tax effective investing may also see a reversal of the sharp
declines in investment holding periods observed amongst investors during the
long bull market leading up to the GFC and through the worst of the GFC.
Interestingly, a tendency for investors to lengthen the average duration of their
investment holdings, has been observed through history following periods of
similar investment upheaval.
c) Dollar Cost Averaging
Investing in environments of high market volatility can be taxing and usually
leads to one of the most common mistakes many investors make – that is the
tendency to panic and sell when markets are falling in price, and to become
exuberant and buy when the markets are rising strongly. The net result of this,
as shown below, is a tendency to dramatically under-perform market returns by
buying expensive assets and selling cheap assets. It is this same emotional
tendency which creates market manias in the first place.
The average investor often does poorly the problem of buying high and selling low
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MLC MARKET INSIGHT
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In seeking to avoid this tendency, Dollar Cost Averaging is a sensible, simple, yet
often ignored rule to bear in mind. By having a disciplined plan to contribute
funds incrementally into your investment portfolio in environments of falling
markets, your investments tend to be on average at prices which prove with
hindsight to have been relatively attractive. It is a basic investment approach
which also avoids the problems associated with trying to accurately market time
your entry into investment markets.
It also has the benefit of seeking to instil a discipline which avoids the tendency
to rushing in to expensive and rising markets and hence becoming exposed to
asset bubbles.
The difficulty with this approach? It can be very confronting for investors to
invest new capital into a falling market. The emotional tendency is to sell along
with everyone else.
However, maintaining this contrarian discipline is
absolutely essential to the success or failure of this approach.
d) Diversification
The other fundamental mistake investors quite often make is to have an
insufficiently diversified investment portfolio - either too little diversification of
stocks within an equity portfolio or too much asset class concentration e.g.
investing only in Australian equities or property. This lack of diversification
almost invariably results in more volatile investment returns over time and
hence a greater risk of large negative returns in certain periods.
A mixed portfolio of Australian equities and international equities is less risky
than a 100% Australian equity portfolio
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MLC MARKET INSIGHT
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10.4
Expected Nominal
Returns (% pa)
100% Australian equities
10.2
10
9.8
9.6
50% International equities (unhedged)
50% Australian equities
9.4
9.2
9
100% International equities (unhedged)
8.8
14
15
16
17
18
19
20
21
Expected Risk (standard deviation % pa)
The above chart uses output from the MLC IM asset allocation model which derives 5 year forward looking
projections for risk and return for various asset classes and portfolio mixes
The principle of diversification is most commonly referred to by the axiom
“don’t put all your eggs in one basket”.
The pitfalls associated with a lack of investment diversity became very apparent
through the GFC where market volatility increased sharply leading to
dramatically negative returns from individual asset classes and securities. In a
post GFC environment it is quite possible that higher market volatility and
general uncertainty will be with us for some time.
By spreading your assets across a number of asset classes you give yourself a
good opportunity to gain one of the few ‘free lunches’ available in financial
markets, that is, you can lower the risk within a portfolio without significantly
lowering your long term portfolio returns.
A portfolio wholly invested in equities can, by adding an allocation to bonds or
cash, significantly reduce risk, with perhaps only a relatively small decline in
long term return potential. How is this possible?
Because the drivers of returns for different asset classes and securities can vary,
these assets often react in different ways to the economic cycle or market
events. It is the resulting low or negative correlation that exists between
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MLC MARKET INSIGHT
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certain asset classes or securities that generates the risk reduction tendency of
asset diversification within a total portfolio.
The most obvious form of diversification is between growth assets, such as
equities or property and defensive assets, such as cash or Government bonds.
The greater risk inherent within the growth asset exposure is balanced by the
lower risk generated by defensive assets. The tendency for these different asset
classes to display low or negative return correlations at a point in time will
generally result in a tendency for risk to be impacted more than return by
mixing varying amounts of these assets within a single portfolio.
However, there can also be worthwhile diversification between differing types
of growth assets. For Australian investors, international asset diversification is
generally an under-utilised but potentially excellent source of risk
diversification. It enables investors to obtain exposure to international growth
markets but with the defensiveness often afforded by foreign currency exposure.
Whilst this may seem counter intuitive, in reality, given the tendency for the
Australian dollar to weaken in an adverse investment environment, then
increasing exposure to offshore equities and currencies at the expense of
Australian equity exposure, can prove to be quite defensive in difficult
investment environments.
In the event of an equity market collapse or panic, as occurred during the GFC,
the tendency for the Australian dollar to weaken at the same time as equity
markets can protect international asset values when they are translated back
into Australian dollar terms.
e) Active Management vs Passive Management
An environment of relatively low overall returns yet relatively high volatility of
asset class returns and a wide dispersion of returns between asset classes and
individual securities, as suggested by a post-GFC environment, best suits an
active rather than passive investment approach.
This is at odds with the general tendency for investors to become disillusioned
with active management following a financial crisis and adopt more passive,
indexation based strategies. Passive management is, in fact, more ideally suited
to an environment of long term trending markets where returns are relatively
high and risk and dispersion of returns relatively low.
By way of illustration, if equity markets are delivering returns of 20% p.a. then
potentially delivering an additional 2% p.a. this from active management is nice
but not necessarily compelling. However, in a more difficult environment where
markets are returning only 6-8% p.a. then an additional 2% p.a. from active
management is relatively much more significant.
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This simple example highlights that when markets are consolidating or trending
sideways the contribution from active management can play a much more
important role in achieving a given level of return.
In addition, there is typically greater dispersion of returns when markets are
volatile. This means that there are greater opportunities for active managers to
exploit these relative value opportunities.
It’s not just about looking to boost returns from active management. It’s also
about risk mitigation by avoiding those asset classes or securities that have a
significant risk of underperforming. Having the ability to avoid the potential
underperformers and focussing on quality investments differentiates active
management from passive approaches.
f) Absolute Return strategies vs Benchmark Relative investing
Absolute return strategies seek to target investments that are likely to deliver
positive returns and avoid investing in assets where returns are expected to be
negative. This is different to a market based or benchmark relative strategy that
measures success by the degree of out-performance above a market based index.
Absolute return strategies are generally unconstrained by benchmarks and
hence have a much higher degree of freedom of investment. This is in contrast
to market based approaches that are often forced to hold investments they have
little conviction in because of the weighting of that investment in an index or
benchmark.
By virtue of the greater flexibility and total return / total risk management
approach absolute return strategies tend to more efficiently utilise risk within
portfolios – what we call using a “risk budgeted” approach to portfolio
management. The aim of these strategies is generally to deliver a higher level of
return for a similar level of risk to a conventional benchmark relative approach
or, to deliver a similar level of return to a benchmark relative approach but with
the utilisation of relatively less risk on average. Either way the approach is
generally aiming to be much more risk efficient in its delivery of returns. The
objective is often to deliver a less volatile pattern of returns over time relative
to a benchmark orientated approach.
A strong focus on risk management means having an allocation to these
strategies in a diversified portfolio during periods like the GFC when markets
are highly volatile is appropriate.
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