The great switchover
The mood of the markets has changed
SOMETIMES the financial markets seem to go in a different direction from the fundamentals.
Global economic forecasts for 2016 are still being revised downwards and the rate of defaults on corporate bonds is rising sharply. But since the middle of February, share prices have rallied strongly while the spread (the excess interest rate over government bonds) paid by corporate borrowers has fallen significantly.
The reason for this divergence is that investors are affected not just by news, but by how the news diverges from their expectations. Things may not be great, but they are not as bad as was feared earlier in the year. In February there were widespread worries about the Chinese economy—concerns that the plunging price of oil and other commodities seemed to validate.
The latest data suggest the Chinese economy is slowing but not crashing; commodity prices have rebounded. In February the Federal Reserve was also expected to tighten interest rates repeatedly this year; now investors think it will move cautiously.
The mood of the markets has changed in other ways too. Rob Arnott at Research Affiliates, an advisory firm, says conditions at the start of 2016 resembled those that pertained in early 1999.
Inflation expectations had been falling, emerging equities and currencies were underperforming and “growth stocks” (in technology, for example) were beating “value stocks”—those that look cheap relative to their peers. All these trends have since reversed. The rebound in commodities has helped sentiment towards emerging markets and pushed up inflation expectations (crucially, investors seem less concerned about deflation). Tech stocks have mostly headed south amid disappointing profits from Alphabet, Apple, Microsoft and Twitter.
The markets’ mood swings may reflect the difficulty in analysing the global economy since the financial crisis of 2008. It has neither recovered as strongly as many expected nor slipped back into recession. In addition, investors face a continuing dilemma. Low (and sometimes negative) yields on cash and government bonds mean that the stockmarket looks like the only plausible source of decent returns. But many wonder whether the bull run in equities, which began in 2009, can be maintained in the face of a sluggish economic recovery and faltering corporate profits. Whenever the economic outlook darkens, investors sell equities. But the sell-offs don’t last long given the paltry returns available elsewhere.
Short-term volatility is not the biggest problem facing pension funds, endowments and insurance companies. A new report from McKinsey, a management consultancy, argues that future investment returns are likely to be lower than the exceptional figures achieved over the past 30 years (see chart).
A lot went right for investors over that period, after all. Inflation declined, allowing bond yields to fall and equity valuations to rise, delivering outsize capital gains; global GDP growth was boosted by the emergence of China and by productivity gains from the internet; corporate profits around the world rose, from 7.6% of global GDP in 1980 to 10% by 2013, by McKinsey’s reckoning.
These trends are unlikely to continue. Bond yields are very low and can hardly fall much further; equity valuations are already high; GDP and productivity growth have disappointed recently; profit margins are high and seem more likely to fall than rise (the slowdown in tech profits reinforces that impression).
McKinsey reckons that, in a slow-growth environment, real annual returns from equities over the next 20 years may be 4-5%, well below the average of the past 30 years; real bond returns may be just 0-1%. Even a rebound in American growth to 2.8% a year might generate real equity returns of only 5.5-6.5%, below the average of the past three decades.
Central banks, by offering support to asset markets in the form of quantitative easing, may have pushed up valuations (and pushed down yields) in the short term. But in essence this means that the markets have “borrowed” returns from the future; from a starting point of higher valuations (lower yields), future returns are likely to be lower.
This has big implications for today’s workers. McKinsey reckons that a 30-year-old will have to work seven years longer or save almost twice as much to afford the same pension as the typical baby-boomer. But with job security weak and wage growth hard to come by, few 30-year-olds will have enough income to ramp up their savings.