Some investors are drawing comparisons with the 1930s and 1970s as indicators of what is to come. Although it is tempting to make parallels with the past, I believe the experiences we will encounter this decade will be unique.
The Great Depression in the 1930s was brutal and had a devastating effect on countries, both rich and poor. It was the significant fall in prices and output that caused the most damage at the time. It is fair to say that while the pain felt recently has been acute, it pales in comparison.
This should not be too surprising because we haven’t experienced a 1930’s style depression. Central banks around the world have been aggressive in their policy response. We have seen extensive use of quantitative easing and headline interest rates have been slashed to very low levels. In contrast, during the 1930s, the US Federal Reserve probably kept interest rates too high for too long.
Cutting rates could have lessened the long period of deflation felt during the Great Depression. Eminent economist, John Maynard Keynes, advocated at the time that countries should target the stability of domestic prices even at the cost of allowing their currencies to depreciate. The current Chairman of the Federal Reserve, Ben Bernanke, would probably agree – after all, he wrote his PhD thesis on the Great Depression. The Federal Reserve’s particularly aggressive policy response during the recent financial crisis is proof in itself. They have slashed the Fed Funds Rate to an ultra low 0.25% and implemented two large rounds of quantitative easing. I don’t think we have seen the end of quantitative easing as a policy tool.
Furthermore, I think the low interest rate environment will also continue for some time. There is a huge deleveraging process underway across governments, companies and households, and this is deflationary.
Fortunately, there are still natural buyers for bonds. Defined benefit pension funds these days attempt to match future liabilities. Banks are also under pressure to improve their capital adequacy due to tougher regulations. In both examples, yields on ‘safe haven’ sovereigns are being supported by these investors. However, government bonds are losing their appeal due to increasing credit risk and low yields. In this following decade corporate bonds could offer a good alternative.
Turning to the 1970s, this was considered to be one of the worst decades for developed economies since the Great Depression. The oil shocks of 1973 and 1979 led to a phenomenon called ‘stagflation’, where inflation and unemployment rose simultaneously. It went against the wisdom of the day that unemployment and inflation had an inverse relationship.
Unsurprisingly, monetary authorities assumed incorrectly that unemployment would drop off as double digit interest rates were set to tackle cost-push inflation. The economic pain felt was immense. Overall, high inflation and woeful investment returns across both equity and bond markets meant that this was a decade where real returns were difficult to achieve. In that respect, it could be similar to the environment we find ourselves in today, even though the inflation background is very different.
Oil prices have dropped recently because of slowing global economic growth, in marked contrast to what happened in the 1970s. Moreover, the shale gas revolution and more efficient methods of oil extraction could see energy prices fall even further, reducing cost-push inflationary factors.
What I think this decade will bring is a revolution in the way investors look at bond markets and consider risk.
The concept of ‘risk free’, which was embellished by the adoption of modern portfolio theory in the 1970s, is now being challenged. Sovereign distress in peripheral Europe, the threat of contagion and rating downgrades have tarnished the image that sovereign bonds are ‘risk free’.
Investors are now looking towards corporate bonds, especially non-financials. Unlike governments and households, many companies have already undergone a significant deleveraging process since the financial crisis. It means that their balance sheets are in good shape and this places them in a better position to tackle any future fall in economic output. This is in stark contrast to many countries that remain heavily indebted and are yet to implement austerity measures.
However, not all companies will deal with the tough economic environment successfully and credit selection will remain extremely important.
Current macroeconomic and political risks are likely to continue over the course of the next decade and will warrant much more consideration. But in a low interest rate, low inflation and low growth environment the rewards for careful credit analysis and selection will significant.
Overall, I don’t expect that either the 1930s or the 1970s will be indicative of what is experienced in this coming decade. However, there are some similarities: the deleveraging process in the 1930s and the difficulty of achieving real returns in the 1970s.
What is clear is that investors will need to have an active and flexible approach to navigate this next period successfully.
6 July 2012
