Where are we now?
The banking collapse of 2007-2008 turned that prediction on its head. Since then, trade volumes have stagnated, and emerging markets are now growing by less than half their earlier rates. Brazil is a political and economic basket case, China is attempting to outrun its debts, but with no certainty that it will succeed, Russia is becoming a poor man’s version of the Soviet Union, and India remains, as ever, full of promise, but short on delivery.
Meanwhile, the west has become prey to political populism as mainstream politicians baulk at the electoral cost of the supply-side reforms required. Despite the efforts of the European Central Bank (ECB), the eurozone remains embedded in deflation, while the US is growing at less than half of its potential.
It is no surprise then that electorates are angry and turning to Donald Trump, Marine Le Pen and even more extreme views – both on the left and right wings – for nationalist and autarkic solutions.
Part of capitalism
For good or ill, these crises are part of capitalism, and happily for investors, this year the analysts of stock markets from the London Business School have chosen to examine (in the Credit Suisse Global Investment Returns Yearbook 2016) the experience of investors after three such events.
These were the truly international banking disasters – the 1890 Baring and Latin American debt crisis and banking panic; the 1930s and the Great Depression; and 2008 and the Lehman Brothers shock, together with the European sovereign debt crisis and, of course, the ongoing Great Recession.
The economy today
Historical comparisons need to recognise changes in reality and, as the authors say, today’s economy is very different from that of a century ago. Servicing is now bigger than manufacturing, governments are far more intrusive with the gold standard just a mere memory, and fiscal and monetary policies are expected to be able to respond to economic shocks.
So although the world economy is now more stable and robust, the actual comparisons show similar falls in employment, industrial production, corporate profits and bank lending.
The world’s response this time around leaned heavily on avoiding the mistakes of the 1930s. Fiscal policy was eased everywhere, and monetary policy concentrated on avoiding further banking failures and an even worse contraction of credit.
This worked but, as the authors say, the risk is to underestimate the power of the deflationary dynamic that was unleashed by the crisis, which is exactly what happened in the 1930s.
Europe is particularly at risk since eurozone rules have much in common with the gold standard, but with no possibility of resignation.
The more successful economies of the 1930s were those that left the gold standard early, while, this time around, the Mediterranean periphery of the eurozone suffered years of GDP decline before the ECB was willing to ease policy to offset these deflationary effects.
Stagnation and reflation
The study finds, “Great financial shocks in the end beget not secular stagnation, but secular reflation. 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.
Reflation is essentially a structural subsidy from savers to borrowers, and [it] normally favours equities over bonds.
Looking forward, we think zero real returns for bonds and 4 to 6 per cent for equities would be a good working assumption, with trend returns on a typical mixed portfolio of bonds and shares down to only 1 to 3 per cent pa from around 10 per cent pa over the last seven years.”
If there is one lesson for successful investment, it is that you should buy when markets are cheap. Currently, there is no possibility of that.
Quantitative easing has flooded markets with money and low yields have driven investors to take on more risk.
Bond and equity prices are at all-time highs. Therefore, investors need to remind themselves of another fundamental lesson: that investment is about the purchase of an income.
Symbolism of money
Bankers and brokers became rich because they understood the symbolism of money
and acted as the middlemen [for a commission] between the rich who need an income from their cash, and other rich people who have a need for liquidity, loans or investors for their assets.
Initially, assets were held in either bullion, property and land, but later through the debts of merchants and governments, and then much later still, the shares of businesses.
Naturally, some of those middlemen, and particularly those with sharper-than-usual trading instincts, saw opportunities for trading whatever paper constituted the assets of stock markets.
The prospects of such profits appealed to the greedy, and with the emergence of well-off middle-class consumers during the 19th century, the modern version of stock market capitalism developed.
However, it was the end of World War II, and the emergence of defined benefit pension funds, together with theories of stock market behaviour, that encouraged popular financial journalism. And from investing for income to buying for capital gains, investment behaviour rapidly changed. The middlemen were delighted as there were now more trades, more commissions, more profits and bonuses.
Hedge your bets
Buying for capital gains is like betting on the horses ¬– you can’t always rely on being right. Nor can ordinary investors be sure that the company they buy for their portfolio will continue to increase profits and dividends, or even pay dividends at all and stay in business.
Therefore, investors need managers, but special sorts of managers. Not brokers – for few of the old-fashioned sort remain – nor private bankers, for this is now a name for above-average banking profits; or fund managers with their theories of alpha, smart beta and rotation risk.
We need controlled and accountable money managers, the ones of the sort that were searched for by the safety-first Victorian middle classes, and are still found among surviving investment trust companies.
Compounded income
As Professors Elroy Dimson and Paul Marsh proved several decades ago, there is no such thing as a capital gain. What there is, is accumulated and compounded income.
How effective this is, when utilised by the average investment trust, was shown in May’s Investment Spotlight column.
The next few years will probably not produce such excellent returns, compared to market averages or alternative managers, but they should at least prevent investors from losing their hard-earned capital or wasting their savings on negative returns.
