Money in a time of financial cholera: part two
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Satyajit Das is a former banker and author of Extreme Money: The Masters of the Universe and the Cult of Risk.
As the global economy resets, the prospects are for lower returns and increased volatility. The US stock market took 25 years to regain its highs after 1929. Japanese stocks (down some 70-plus per cent from their peak) and property markets (down between 50-70 per cent) have still not recovered the levels of 1989.
Since 1912, as Pimco's Bill Gross has argued, equities have returned an unsustainable 6.6 per cent per annum in real terms, well above real GDP growth of 3.5 per cent per annum. Now, growth itself is slowing, affecting corporate earnings and equity values.
Recent strong corporate earnings were driven by cost cutting, government stimulus and low interest rates. Slow growth will constrain already indifferent revenue levels. Without underlying demand for their products, corporate profit margins and earnings will be under pressure.
Corporate earnings in emerging markets will be affected by the sluggish growth in developed markets and the slowdown in China, India and Brazil, the regional powerhouses.
The Viagra of investment - the leverage that drove high returns pre-2007 - is unavailable as the global economy reduces debt.
"Official" interest rates are low but credit margins are high. With inflation low, the real cost of borrowing remains high. The overall supply of credit is likely to fall as European and American banks cut balance sheets' size. Risk-averse companies and individuals are also more cautious about borrowing, after recent near-death experiences.
But the effect of policy actions on equity markets is difficult to gauge.
Equity prices may be supported by low interest rates, which reduce holdings costs, and dividend yields, which are above bond interest. Based on the Japanese experience, further rounds of central bank buying of risky assets can be expected. The range of assets bought may expand to include equities and corporate bonds, which would boost prices.
A case of style
Investment structures compound the investor's dilemma. Traditional mutual funds are structured to generate relative returns measured against a benchmark.
Unfortunately, beating a benchmark by 5 per cent provides cold comfort to investors when the investment manager is down 15 per cent and the market falls by 20 per cent. Only absolute return now counts.
Management fees and fund expenses are a significant drag on returns. Management fees and expenses of 2 per cent are tolerable when the returns are 12 per cent but difficult to bear when the returns are 5 per cent or lower.
In choppy markets, rapid changes in the composition of portfolios, including switches between assets and instruments (physical versus derivative, symmetric versus asymmetric exposure), are required.
Long periods of staying uninvested, holding cash or other defensive assets, may be necessary.