By Marino Valensise
The term ‘financial repression’ is often used to describe the policy of central banks following the global financial crisis: the artificial depression of interest rates through standard monetary policy as well as unorthodox tools such as quantitative easing.
One important consequence of these policies has been the compression of volatility and the lower dispersion of returns between countries, sectors and individual stocks in particular. This has created an environment in which the ‘macro trade’ has, over the past six years, offered higher return opportunities than highly active (alpha focused) management strategies.
Interest rates are a key input in the valuation of all assets. For bonds, this is straightforward: lower yields mean higher prices. For other assets, if a lower rate is used in the valuation formula (i.e. the discount rate), this will lead to a higher asset price. Consequently, driving rates to historically low levels has driven assets to higher prices than they would have otherwise achieved. In such an environment, equity markets deliver significant returns, which are boosted by financial repression.
Each year, Barings’ multi asset team produces 10-year market return forecasts, where we step back from the day-to-day movements of the markets to think about the secular issues which drive markets over the longer term. In our latest forecast, we have stated that we expect central banks’ influence on markets to remain for years to come. There are two reasons why we believe it will continue for the foreseeable future, albeit in a less aggressive form: the first is the unsustainable accumulated stock of private and public debt; the second is the likelihood of unacceptably high volatility in any attempt to transition to a more ‘normal’ regime.
As the US economy improves, we are approaching the first tightening of Federal Reserve monetary policy in 11 years. How well will the Fed manage this event? How will market participants react? How will they safely unwind the distortions brought about by financial repression?
Any exit is going to be problematic; a transition to a world which is less borrower-friendly could be traumatic. Fears of such an event have already contributed to a few episodes of deep volatility, with investors unwinding leveraged trades which had previously been seen as one-way bets. This volatility may constitute an uncomfortable new reality for investors. Will central banks be able to tolerate it?
Higher volatility would also mean uncertainty for financial investors, corporates and consumers, which would impact economic conditions. We do not believe the authorities could tolerate such an outcome.
This view on continuing financial repression leads to a series of conclusions. First, we do not expect a sudden and disorderly return to equilibrium, which could deliver a negative shock to the global economy and precipitate a true depression with unknown consequences.
Second, we forecast a continuation of lower-than-normal bond yields, with all of the associated benefits and problems. On 10-year US Treasuries, we see an end-of-period 3.6% yield, instead of a more logical level of 4.6% which should have otherwise prevailed. Looking at nominal annual returns, we expect developed government bonds to deliver no more than 2%, which is equivalent to zero in real terms.
Third, we envisage that market manipulation will continue to support equity valuations; history shows that, during periods of financial repression, investors are willing to tolerate higher price-to-earnings multiples. For the S&P 500, we see an end-of-period price-to-earnings ratio of 17.3x instead of a more rational 16.4x. On the equity side, we expect nominal returns between 3% and 7% in sterling terms, which will represent real returns between 1% and 5%.
Because of financial repression, our 10-year forecast of total nominal and real returns looks quite disappointing for most asset classes. A sterling-based portfolio allocated equally between bonds and publicly-listed equities would deliver a nominal return no higher than 4% per annum. These returns might not be compatible with the asset return assumptions formulated by many defined-benefit pension plans.
We believe that investors who are relying on much higher return assumptions, therefore, will have to go beyond a static allocation to the macro (or beta) trade. Instead, they must dedicate a considerable amount of time to other sources of return, such as an active, dynamic approach to asset allocation focused on timing asset classes but also equity geographies, sectors and styles, and also focusing on alpha generation within each asset class, in particular equities.
Marino Valensise is head of the Multi-Asset Group at Baring Asset Management
Comments