Market Commentary

Q2 2015

We have for some time cautioned investors that future returns from equities will not match those of the past. It is probably worthwhile to expand on the reasons for this. At the macro economic level, the Great Recession has indelibly focused governments and central banks on the need to cut back spending and reduce budget deficits. Given the massive levels of sovereign debt that were allowed to accumulate, it is clear that this process will persist for many years to come. Europe, and especially Greece, are painful examples of the negative effects of profligate over-expenditure.

Banks have also adopted more stringent lending practices, learning from the high cost of their earlier cavalier growth-oriented strategies and as a result of the almost overzealous new regulation. Lower bank lending and reduced government spending are reducing the growth potential in a world already experiencing the impact of declining growth rates in China, which has been the main driver of world growth for almost a decade. [CHART 1]

Tangible evidence of this ‘new normal’ is reflected in the IMF forecasts. Whereas between 2001 to 2007 advanced economies grew at a real annual rate of 2.2%, the IMF’s forecast for the post-recession period 2015 to 2020 is just 1.6% real per annum. [CHART 2]

Slower economic growth inevitably impacts negatively on corporate results. This has been masked in recent years by significant cost savings and the containment of wage increases by companies. With employment levels back to normal, or near normal, in most major economies, this benefit is fading rapidly. In addition, earnings have been boosted by low interest rates and extensive buyback activity – enabling earnings growth to far exceed sales growth. This is also likely to be less of a positive going forward.

The cocktail of reduced government spending, more stringent bank regulation, slower growth in China, fading cost-saving opportunities for corporates and rising interest rates, ensures slower earnings growth. Combining this with the demanding current valuation levels, the prospect of reduced future returns from equities is almost inevitable.

As if this subdued outlook is not enough, it seems clear that volatility levels will increase (probably sharply) in the near to medium term. This is likely because the market is ‘priced to perfection’ and, at current elevated levels, is clearly more vulnerable to unexpected shocks than if valuations were markedly lower. [CHART 3]

One such shock could occur in the bond market. Several of the world’s largest money managers are positioning themselves for a potential crisis. The concerns relate, firstly, to the massive increase in the issuance of bonds in recent years. With money market rates near zero, investors piled into bonds, either directly or through bond funds to capture better yields. On the supply side, corporates used the opportunity to raise funds at historically low rates. In Europe and the UK the level of issuance in the two years prior to the Great Recession was less than $300bn, whereas in 2013 and 2014 it exceeded $435bn in each year.

Secondly, over the same period liquidity in the bond trading markets began to dry up – primarily due to tough new regulatory curbs on banks’ proprietary trading and their more stringent capital requirements. The value of bonds currently held by US corporate dealers has fallen by 75% from 2008 levels and RBC has expressed the view that liquidity in the US credit markets has dropped by about 90% since 2006. [CHART 4]

Should rising rates cause investors to flee the credit markets to avoid capital losses, the market would be swamped with sellers. Ordinarily the markets would probably have been able to handle such a deluge. This is now by no means certain and wild price fluctuations could occur.

The effect would not be confined to bonds, as a sharp decline in investment sentiment generally would occur and spill over in no small measure into equities as well. A tail risk, maybe, but a risk nevertheless