Sunday, 22 July 2018

The tough part is only beginning

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  • James Saft - June 2014

The first few years of the recovery were relatively kind to investors, but with bonds likely to be a dead weight on portfolios for years to come, the hard part is only just beginning.

While negative interest rates are unprecedented, very low ones in the aftermath of financial blowups are not. There are, perhaps, two reasonably comparable periods to where we now find ourselves as investors: after the Great Depression and after the far less well known crisis of the 1890s. If those two earlier crises set the pattern, investors are looking at an extended period of sub-par returns.

Worse still: diversification won’t be of much use.

“The main lesson to be drawn from comparing crises … is that great financial shocks in the end beget not secular stagnation but secular reflation,” writes Jonathan Wilmot, head of macroeconomic research at Credit Suisse Asset Management.

“By secular reflation, we mean at least a decade in which short- and long-term interest rates stay habitually below nominal GDP growth and high-grade bonds are not really bonds anymore: delivering trend returns that are close to zero or even negative.”

As part of its 2016 Global Investment Returns Yearbook released this month, Credit Suisse examined the experience of the Depression and the post-1890s periods and came up with a working assumption of zero real annual returns from bonds and just 4% to 6% for equities in upcoming years. That works out to an overall portfolio return of just 1% to 3% yearly, as compared to the 10% or so we’ve enjoyed since the depth of the crisis in 2008.

You can think of it as financial repression or simply as the subsidy of those who owe money by those with savings, but the result is the same. Interest rates in similar periods have been depressed for long periods but the reflation has resulted in huge losses for bond holders.

And these periods of negative or very low bond returns can last not years but decades. US government bond investors saw a loss of about half their capital in the 20 years from 1900, which roughly equates to where we are now. After the Depression the ‘recovery’ was even worse for bond investors: a loss of about 65% between 1941 and 1981, Credit Suisse calculates.

Argentina and Barings

There are obviously a lot of differences between today and the two earlier episodes, not least that we are no longer on a gold standard, allowing central banks more latitude in cushioning the impact. So, while GDP fell less sharply this time around, many other measures are now tracing a very similar path to that of the 1890s, including industrial production, unemployment and corporate earnings.

The 1890s crisis had its roots in Argentina, which suffered a debt crisis and defaulted after a classic influx of hot and dumb money, much of it British. That led, in turn, to a run on Barings Bank, which was bailed out but not before sending shock waves around the world, leading to a widespread banking panic and credit crunch.

Thus far US equities are behaving very similarly to how they did in the 1890s, and the relationship of debt and equity returns is also similar. But once the early stage of the recovery is past, the long after-effects of the crisis are still felt. The first decade of the 20th century had bond returns of negative 1% annualized in real terms, and equity returns of 6 percent on the same basis. In the decade from 1939, which included the war, real bond returns were negative 2% a year and equities only plus 3%.

Credit Suisse argues that, just at the point at which so many investors have gone passive, the benefits of active management will come into their own. I’m less sure.

Taking on more risk in fixed income portfolios seems unlikely to make up much of the ground lost to rising interest rates which will, after all, make highly indebted borrowers less creditworthy and more likely to default. It is easy to see a lot of equity investors taking on more risk, but it is hard to see them collectively discovering some new supply of outperformance to make that risk pay off.

The real lesson of the 1890s and 1930s may be to lower expectations and increase savings.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at

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