Morgan Stanley’s Graham Secker makes some interesting observations in his 2012 outlook report.
Chief among them is that the investment framework of the last 25 years is increasingly irrelevant and that Japan offers the best guide to what might happen in the equity market over the next decade.
And that’s important because a lot of people are still living in the past and using heuristics to predict what will happen next.
If we use the investor framework of the last 25 years, equities could see a strong performance in 2012. Many investors consider equity valuations to be low, policy makers are/about to pull out all the stops, the world is awash with cash, corporate balance sheets are strong and, even if Europe is falling into recession, history suggests that equities trough at the beginning of such an event. Some of this reasoning is likely to drive tactical rallies in equities in 2012.
However, we believe that the ending of the debt supercycle in developed markets renders this template obsolete in the longer term. In this context, we believe equities will again struggle through 2012 as they deal with weak growth, the limited efficacy of policy initiatives, social unrest and average, rather than cheap, valuations.
In fact, Secker reckons 2012 will be our first full taster of what to expect over the next decade, and it’s not a particularly pleasant concoction.
Looking back at 2011, there was a multitude of significant events to interest historians, financial or otherwise. For us, the most important development for investors has been confirmation that we have reached the end of the debt supercycle in developed markets. In Europe, we can support this hypothesis by noting the sharp deterioration in GDP growth and growing stress in the majority of government bond markets. While these signposts aren’t necessarily apparent in the US, the loss of its AAA rating over the summer is likely to be a precursor to further developments over the next couple of years. Of course, the ending of a debt supercycle – and the consequences for investors – play out over a number of years.
To ascertain the longer-term impact of deleveraging, there are, of course, only two historical examples to draw upon: the US in the 1930s and 1940s and Japan over the past 20 years.
Secker reckons Japan is the most pertinent for Europe, although it’s by no means a perfect comparison. Japan, for example, never experienced a sovereign debt crisis, in spite of debt-to-GDP ratios in excess of some PIIGS.
Still, it can provide a guide for investing over the next decade, thinks Secker.
And here it is:
1) Economic growth will be slower and more volatile. In the 20 years prior to the bursting of the Japanese bubble at the beginning of the 1990s, Japanese per capita GDP grew by an average of 3.4 per cent, with just one recession in 1974/75. However, in the subsequent 20 years there have been six recessions, and per capita GDP growth has averaged just 0.8 per cent.
2) Fiscal policy is increasingly important when interest rates are very low. When the private sector of an economy is in deleveraging mode, interest rates are likely to stay low for a long period; however, a lack of appetite for debt means that their ability to generate growth in an economy remains poor. If rates stay low for a long period, the lack of change also means that rates no longer exert much influence on economic growth on the upside or the downside. Instead, economic activity is predominantly affected by changes in domestic fiscal policy and the external growth outlook (i.e. exports).
3) Equity performance will be weak and volatile. Between 1970 and 1990, Japanese equities produced an 8 per cent CAGR price return in absolute terms and outperformed global markets by 16% per annum. Since 1990 the figures are -8 per cent and -6 per cent respectively. If we exclude the extreme upside and downside of the late 1980s/early 1990s, we note that the median rolling return over any 12m period between 1993 and 2007 was 2%. This compares to 12% for MSCI World.
Seckers says its very important for investors to understand point 2 and what the end of the debt supercycle means. In this environment, policymakers have a real impact on economies and asset classes. As do geopolitical factors. Not credit and borrowing.
Indeed, the structural change in fiscal policy as nations attempt to pay back some of what they owe, is likely to have a big social impact, Secker says.
As consumers experience declining living standards for the first time in a decade, we can expect strikes, unrest and political instability.
For investors, the ramifications of this process are likely to be:
1) more social protests and economic dislocations, such as strike action;
2) increased political turnover as the electorate churns its politicians on a regular basis in the hope of protecting its living standards;
3) an increase in ‘populist’ policies from governments as they aim to align themselves with the wider electorate;
4) Higher taxes – Exhibit 19 shows how corporate tax rates have been falling for the past 30 years, while Exhibit 20 shows how the marginal top rate of US income tax rose from 30 per cent to 90 per cent in the decades post the Great Depression of the 1930s.
Crikey, things really do look GRIM.
On a brighter note, it will be Christmas soon.
Related link:
European equities – trick or treat? – FT Alphaville