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12 April 2024

Era of capital scarcity on the way

By Paul Murphy

Around this time each year, with something of a flourish, Barclays Capital publishes a substantial tome called the Equity Gilt Study. It is one piece of investment research that has been published continuously since 1956, making it one of the hardiest perennials in the investment world.

What makes the publication special is the Equity Gilt Study's determination to take the long view. Comparing the performance of a range of financial assets over the decades, the relevant US data goes back to 1925, while the UK data goes all the way back to 1899. It gives the reader some serious perspective on long-term asset returns.

The study also tackles some up-to-date themes. A clue to the authors' thinking while compiling the 2010 study is in the selection of quotations on the inside cover:

Greed, for lack of a better word, is good – Michael Douglas as Gordon Gekko, Wall Street, 1987

Earth provides enough to satisfy every man's need, but not every man's greed – Mahatma Gandhi

Greed is a bottomless pit which exhausts the person in an endless effort to satisfy the need without ever reaching satisfaction – Erich Fromm, 1941

Excess of wealth is cause of covetousness – Christopher Marlowe

But given the concentration on the long-term it makes sense to concentrate here on what the long-term numbers tell us. Let's focus on the UK.

Consider the first table here – a summary of real investment returns from five asset classes over various time horizons. According to BarCap, equities emerged from the credit crunch to post the best annual returns in 20 years during 2009. From the March lows, global equities rallied 60 per cent, with financial stocks leading the way, and the FTSE Global Banks index ended the year 145 per cent higher from the March trough. But despite the impressive ending, the noughties proved to be a disappointing decade – the average annualised real returns over the past 10 years have been the worst since the stagflation of the 1970s.

You will see from the table that both cash and gilt-edged stock suffered as risk hungry investors piled into the London stock market. So gilts switched from being the best performing UK asset class in 2008 to being the worst performing last year. However, if you take a longer-term view it is clear that gilts have outperformed equities on both a 10 year and 20 year view – not good news to those legions of investors who have been brought up to believe that equities, while carrying more risk, would always out-perform government debt if held for the long term.

Now consider the second table here, which breaks down real asset returns for consecutive 10-year periods. Here's BarCap's commentary:

"Gilts produced the best performance over the decade, marginally outperforming cash. Equities produced the worst 10-year performance since the 1970s. Ranking the annual returns and placing them into deciles provides a clearer illustration of their historical significance. The results for 2009 are shown in Figure 38. The equity portfolio is ranked in the second best decile since 1899. This is a remarkable turnaround from 2008, which ranked in the worst decile including the Great Depression, the Opec crisis and the dot-com crash. The ranking for gilts has deteriorated from the second to the seventh decile. Meanwhile, inflation-linked bonds moved up from the ninth to the fifth decile as the deflation fears that dominated during the credit crunch faded. The ranking for cash fell from the third to the fifth decile as yields were held near zero."

Which brings us to the flagship essay in the 2010 Equity Gilt Study, penned by Tim Bond, a long-standing favourite of this column and also head of asset allocation at BarCap. His thesis this year is that recent financial crises can be traced to startling changes in underlying global capital flows, generated first by the rise of the baby boomer generation in the developed West, along with the rapid increase in per capital income in the large developing economies.

Says Bond: "An abundance of global savings seemingly weakened the collective discrimination of risk and reward in investment, resulting in serial misallocations of savings and asset bubbles."

The strategist adds that this demographic trend may have peaked, which may lead to us seeing fewer financial bubbles. But he warns that the same population dynamics could be very bad for bonds over the coming decade.

Echoing those quotations alongside the front cover of this year's study, Bond declares:

"Given the apparently abrupt end to a prolonged period of halcyon economic conditions and the revelation of pathological behaviour by some financial institutions, it is unsurprising that the popular interpretation of events is that greedy financiers killed the Great Moderation. Such an explanation is certainly easy to explain and easy to understand, but it is also superficial and incomplete. Unfortunately, the 2007-09 credit crisis was merely one particularly disruptive episode in a series of similar financial crises that began to occur with increased frequency late in the last century."

He prefers a volcanic analogy, where tiny moves in landmass over many years suddenly produce an eruption. Yet if we are now likely to see fewer eruptions because destabilising flows of capital are reducing with demographic trends, what does that mean for future asset prices?

According to our demographic bond models, longterm government yields in both the US and UK are set to more than double from current levels over the next decade, moving up to around 10 per cent by 2020. Under such circumstances, total returns from government bonds are likely to be negligible over the next decade."

That's a scary prospect. What the BarCap man is saying here is that over the next two decades we will see the boomer generation in the West move into retirement and run down their savings. The era of capital abundance will become an era of capital scarcity, just as government debt burdens are rising sharply – a move that in itself will cause investors to demand higher yields for holding riskier government paper.

Paul Murphy is associate editor of the Financial Times. Views expressed are his own


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