the challenge of investing ... - economic perspectives · june 2016. discretion is the better part...
TRANSCRIPT
The challenge of investing prudentlyin doctored markets
Prepared for Ruffer Charity Investment conference
Peter Warburton
June 2016
Discretion is the better part of valour
• Introduction: the changing policy landscape for ‘prudent’ investing
• Differences between conventional and unconventional policies
• Four elements of the changed policy landscape:Experiments with negative nominal interest ratesStrategies to repress government bond yieldsStrategies to tighten corporate credit spreadsStrategies to discourage assumption of financial risk
• Net impact of all these actions for the risk-reward trade-off
• Paradox of policy easing: actions intended to induce more economic risk-taking are having the opposite effect on investors
• How charities should respond to this changed landscape: discretion is the better part of valour
2
Taking stock of unconventional policy measures
• Financial repression, quantitative and qualitative easing, forward guidance etc.
• Reducing short-term interest rates to zero or even negative
• Large-scale official purchases of government bonds
• Lengthening the duration of officially-owned government bonds
• Large-scale official purchases of mortgage bonds and corporate bonds
• Small-scale official purchases of commercial paper, ETFs and REITs
• Communication strategies designed to influence market expectations of the path of future interest rates
• Regulatory enforcement of capital, solvency, liquidity and leverage ratios on commercial banks and insurance companies
• Regulatory discouragement of proprietary risk-taking by investment banks
3
What’s different about unconventional policies?
• There has been rapid innovation in design of unconventional policy
• Untried and untested: it is often unclear how they work or even ifthey work
• Difficult to calibrate: inbuilt bias to excessive use
• Difficult to withdraw: fear of negative implications
• In contrast to movements in interest rates across their typical range (eg 2% to 7%), the impact of interest rate changes outside this range are asymmetric across businesses and individuals
• Unconventional policies tend to have concentrated impacts on financial asset prices, favouring those who own these assets
• Every country has adopted a different mix of policies – no agreement as to the optimal policy mix
• Unconventional policies in advanced economies have unexpected spillover effects on emerging economies
4
Financial objectives of unconventional policy
• Doctoring of financial markets
• Removing the savers’ reward: denial of the opportunity of a positive real default-risk free return on cash – and in some cases of even a positive nominal return
• Crushing the term premium: lowering real default-risk free returns across the maturity spectrum, as nominal bond yields plunge below zero in Europe and Japan
• Keeping government bond volatility low: enhancing its reputation as ‘safe’ asset
5
Nominal interest rates are dragged down the page
• Policy rates (short term interest rates), developed economies
6
-2
-1
0
1
2
3
4
5
6
7
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
% pa
US EU Japan UK Canada Switzerland Sweden
Source: CEIC
Historical real returns on short-term deposits
7
All developed markets offered risk-free real income
Source: CEIC
Average real short term interest rates (1998-2007)
Current real returns on deposits have evaporated
8
Few developed markets offer positive real income
Current real short term interest rates (April 2016 or most recent)
Source: CEIC. Short term interest rates (commonly used national definitions) for April 2016 (or most recent available data) and the corresponding headline CPI inflation
The real return conundrum
A Zero default risk and zero duration, ie T-bills
B Zero default risk and positive duration (ie govt bonds)
C Positive default risk and positive duration (eg equities)
D Positive default risk and positive idiosyncratic risk (eg private equity funds)
9
Pre-crisis curve
Impact of additional financial regulation
Penalising and deterring the assumption of risk
Post-crisis curve
Risk/volatility
Impact of unconventional monetary policy (eg QE)
Real return
AB
C
D
Unspoken financial objectives of unconventional policy
• Doctoring of financial markets
• Credit easing: encouraging risk-taking in corporate bonds and emerging market bonds as investors ‘reach for yield’
• Institutional coercion: using financial regulation to steer asset allocations towards government bonds
• Risk-reward interference: exaggeration of the equity risk premium to lure non-institutional investors into equities
10
What is the equity risk premium?
• Historical or prospective excess return to stocks over government bonds
• ERP = dividend yield on equities + estimated growth rate of dividends – estimated risk-free rate (usually proxied by a long-term government bond yield)
• Long-term average ERP in western financial markets is about 4% (400 basis points)
• When the ERP is higher than 4%, this suggests that it is a good time to buy equities relative to bonds – equities offer a tempting excess return: Fear>Hope
• When the ERP is lower than 4%, this infers that equity price may be vulnerable to a fall: Hope>Fear
• Estimated ERP for developed markets lies in the range of 5% to 7% currently: does this mean that equity markets are good value?
• Or have central banks engineered a high ERP as an invitation to risk-taking?
11
Conventional interpretation of the US ERP
• Implied premium for US equity market, year end 1960-2016
12
Source: Aswath Damodaran
Oil price, inflation shocks
Steady sixties
Technology boomand bubble
Financial crisis
Premium has widened for Europe ex-UK
• Equity risk premium: developed markets
13
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
UK North America World Europe ex UK
Source: Bernstein Research
Future dividend growth may be much lower than today
Although the payout ratio has some further scope to increase
US ERP estimates for dividend growth
14
-4
-2
0
2
4
6
8
10
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015
10 year smoothed nominal GDP growth 10 year smoothed dividend growth
Source: Economic Perspectives calculations
High ERP induced by low/negative real bond yields
• Repression of real bond yields
15
US ERP versus real bond yield, 1970-2016
Source: Aswath Damoraran www.pages.stern.nyu.edu/~adamodar
2016 versus 1981: the contrast
• On both occasions the US ERP was around 6%
• In 1981, the nominal US 10-year Treasury yield was 14%, and expected to fall
• In 1981 US equities were unambiguously attractive: ERP likely to fall and nominal Treasury yield (embodying historic inflation), expected to fall.
• In 2016, the nominal US 10-year Treasury yield is below 2% and expected to rise
• Not so in 2016: if real bond yields remain low, or even fall further, the ERP is unlikely to fall and nominal Treasury yields are expected to rise
16
The role of stock and bond market volatility
• Ratio of rolling 20 year stock market volatility to bond market volatility, 1971-2015
17
Source: R Shiller
ERP correlates with excess stock volatility
• Ratio of annualised monthly stock to bond volatility versus ERP
18
Source: Clifford Asness, Financial Analysts Journal, 2000
1988
1968
1928
1908 1948
Equity volatility and sequence risk
19
Equity volatility arises principally from occasional crises• Over the past 30 years, the profits of North American and Western
European multinationals have more than doubled, to around US$130trillion, which is much faster than global GDP growth
• Global corporate after-tax profits rose from 7.6% of GDP in 1980 to 9.8% in 2013 as companies extended their global reach into emerging markets
• Almost one-third of all US corporate profits are derived from overseas, compared with about 15% in 1980
• Since 1990, global equity returns have advanced in 3 long waves of improvement, partly offset by 2 abrupt corrections. We may well be on the threshold of a third correction. This pattern gives rise to the phenomenon of sequence risk
• Risk of long-lasting impairment to returns if equity drawdown occurs soon after commitment of funds
Understanding the importance of sequence risk
• Global equity prices in local currency
20
Source: Thomson Reuters Datastream
Summing up: how policy has distorted the markets
• Equities are considerably less attractive relative to bonds than they appear
• Real returns to cash have been driven negative
• Real returns to duration in government bonds have been compressed
• Falling real bond yields have introduced an upward bias to the ERP
• Today’s high ERP should be treated with suspicion because:
- financial repression implies that real bond yields will not recover, meaning that the ERP will not revert to its (lower) mean
- for dividend growth to be sustained at current pace in a much lower nominal growth environment requires progressive rise in the payout ratio
- suppression of bond volatility, in relation to stock volatility, implies that ERP will stay permanently higher
- interest rate normalisation may be disruptive to equity valuations
21
The real return conundrumReal return
22
Pre-crisis curve
Impact of additional financial regulation
Penalising and deterring the assumption of risk
Post-crisis curve
Risk/volatility
Impact of unconventional monetary policy (eg QE)
A Zero default risk and zero duration, ie T-bills
B Zero default risk and positive duration (ie govt bonds)
C Positive default risk and positive duration (eg equities)
D Positive default risk and positive idiosyncratic risk (eg commodities)
AB
C
D
Responding to the souring of the risk-reward trade-off
23
Unconventional policies have passively induced higher risk profiles for endowments• Investors have pursued alternative strategies and asset classes (eg
hedge funds, commodity funds, currency funds, risk parity funds, illiquid strategies etc) in a search for additional yield/return
• Quantitative strategies that employ algorithms constitute forms of passive investment that disconnect investors from the underlying rationale for holding their investments, leaving mangers and trustees exposed to censure
• Some also involve the active use of leverage, which bears its own dangers. Yet active investors struggle to justify their management fees in an environment of diminished returns
• Sequence risk in equities could have a material impact on market valuations
• Protective strategies are required alongside growth assets to guard against the excessive and unintended assumption of capital risk
