Any port in a storm after bursting of the bubble Stuart Washington September 11, 2010
THINK for a moment about what has happened across the world's financial markets in the past three years.
In that time the biggest financial bubble in history reached its peak. Forget about tulips and the lure of the South Sea. The world was on a debt-fuelled binge of which practically no one understood the full extent.
When the bubble popped, the world's banking system was found wanting as the financial system suffered the largest-ever collapse in asset values.
There followed the biggest period of concerted government spending the world has seen as politicians tried to repair the damage to the banks.
Do things go back to normal after that? And - depending on your perspective of how long the bubble was building - what was normal anyway?
Many in Australia fear there have been fundamental changes that are yet to be fully understood.
They argue that these changes have raised fundamental questions about how equities should be regarded in the altered environment.
Worse, their arguments mean there are few havens, with the other great mainstay - government bonds - trading at historically low prices.
How these views square with Australia's economic health is just one of many mixed messages.
The overall critique does, however, allow for short, sharp bursts of economic well-being as Australia moves from "the great moderation" beloved by economists to what may well become known as "the great volatility".
One of the most powerful analyses of the situation comes from Michael Schneider, chief investment officer and co-founder of Melbourne-based fixed-interest fund manager Vianova Asset Management.
Schneider is an unassuming fund manager who reads widely; his notes feature quotes from eminent physicist Niels Bohr, among others. Schneider stayed well away from the toxic effluviums such as collateralised debt obligations being peddled as fixed-interest investments at the height of the crisis.
"We do not believe the global credit crisis has been resolved by any stretch, and in fact we believe risks in the global system are actually compounding," Schneider wrote in a note to clients this week.
Vianova is therefore paying special care when constructing
fixed-interest portfolios: an emphasis on liquidity and short-term positions giving an ability to react to situations.
"It's not about being right at the end - it's about being there at the end," says Schneider in an interview.
For Schneider, the world has entered a period of "asymmetric risk", or unknown consequences from unprecedented events.
"This is deeper than a cyclical issue, this is a structural issue and, of necessity, will take far longer to resolve," he says.
He sees part of the resolution as the end of 30 years of benign interest rates and resulting credit growth that allowed an unprecedented period of asset-price expansion. Or, put more, simply, the bubble was 30 years in the making.
(To understand how asset prices grew as interest rates fell, you need only reflect on how big a house you can afford with a mortgage at 15 per cent interest. Now think about how big a house you can afford with a mortgage at 5 per cent interest. The effect of low interest rates meant the whole world was seduced into paying more for the bigger, better house.)
So for Schneider, there is no "normal" because we haven't been in this place before. How does the world move from a period of credit creation to a period of credit contraction? Who wins, who loses?
"If you have unprecedented levels of interconnectivity and unprecedented levels of credit creation it's very likely you are going to get unfathomable outcomes," he says.
Schneider is a fixed-interest manager. Fixed-interest managers are stereotyped as perennially gloomy and risk-averse, nothing like the fly boys and girls of the equities markets. Schneider is, however, not alone in his analysis. His views resonate with a theory promoted at the very hub of the equities market by Macquarie Group's equity strategists.
For more than a year, Macquarie's Tanya Branwhite, repeatedly rated the top equity strategist in The Sydney Morning Herald-East Coles best broker rankings, has argued that things have changed fundamentally for sharemarket investors.
She singles out 15 years of benign economic conditions for most Western economies. The period was characterised by low interest rates, an increase in world trade and China effectively exporting deflation through ever-lower prices for its goods.
"We think a lot of the underpinnings of that 15-year cycle have now gone away," she says. So for Branwhite, the "normal" that most adults think of as the robust economic growth of the past 15 years was anything but normal.
"I think the last 15 years were abnormal,'' she says. ''I think now we have gone back to a more normal setting.''
She sees the listed property trust sector as an example of changes in the broader equities market. Banks have pulled back their lending. Companies have worked hard to restore their balance sheets. Distributions have been cut to align payments to underlying cash flows rather than Ponzi-style payments out of fresh capital raisings.
Branwhite says there are several consequences for the broader market of this kind of behaviour.
For starters, return on equity - what shareholders make on their shares - is down because companies have cut their debts and increased the number of shares on issue.
Australian companies, excluding property trusts, have cut their debt levels from more than 60 per cent at the height of the bubble to almost 30 per cent in July this year.
The maths on this is easy. Return on equity is just net profit divided by the amount of shareholders' equity. If the denominator goes up - and it goes up substantially every time you issue new capital - your overall return goes down.
But Branwhite and her team also point to a return to a pre-1995 normality of short, sharp macro-economic cycles, far from the overall benign environment enjoyed by business since then. In the team's latest note on the issue released in late May, Macquarie equity strategists noted: "We believe there is a high probability that we are returning to 'big and sharp' economic cycles seen in the '70s and '80s. If correct, this has major implications for both the volatility of corporate earnings and, most importantly, equity returns." The team states the two major consequences are frequent swings in risk appetite due to high economic volatility and lower long-term economic growth on average.
Branwhite says the outcome is that equities are no longer a simple buy-and-hold of most-favoured companies. For example, she says the team believes retail stocks will perform strongly now - but would possibly not perform so well in nine months.
The shorter period for expected payoffs also has a perverse effect on the prices of shares more generally.
Because investors no longer are prepared to hold for a longer period, they are no longer prepared to pay for the longer-term "growth" that may have been embedded in the share price previously.
The net result is share prices with an in-built leaning to go down due to the whole market being attuned to the rapid rises and falls of the economic cycle rather than a company's performance.
The note explains: "The economic cycle is so short that by the time improved company earnings are starting to be delivered, the economy is already showing signs of entering its next downturn. In these conditions, stock investing in the market becomes more like investing purely on anticipation of the cycle - you 'buy the rumour' of improving earnings to come and you sell out before these earnings are actually due to be delivered."
It's the kind of recipe that makes value investors' teeth grind: trying to time your entries and exits against macro-economic unrest, rather than allowing the intrinsic value of a share to shine through.
The longer-term value of shares for investors is being questioned in other ways as well.
Perpetual group executive Richard Brandweiner and diversified funds portfolio manager Michael Blayney are reassessing the contribution that equities make to portfolios more generally.
They have asked fundamental questions about whether investors are getting what they hoped for when it comes to equities.
Blayney's analysis of share returns in the US over the past 100 years shows that when looked at in 10-year periods, shares failed to make an annual average return of inflation plus 5 per cent in five of them.
A benchmark of inflation plus 5 per cent is seen as the goal for successfully investing over a longer term to meet the needs of retirement.
"Because of the effect of sentiment, equities are actually riskier than what's often perceived," Blayney says.
"People say, equities are fine if you have a 10-year time horizon. Well, the analysis shows that actually with equities you need a very long time horizon before you have a reasonable certainty of being paid back."
Amid this questioning, Brandweiner and Blayney have also examined the higher interest costs now being paid in Australia.
Their analysis shows short-term loans to the vast majority of Australian-listed companies are at interest rates above the historical average of the past 12 years.
The net effect of this kind of analysis is fundamental questioning of how much equities should contribute to investment strategies.
And it is not hard to see that current settings of equities making up about 60 per cent of a superannuation fund's "balanced" option are being closely scrutinised.
"If you can be a lender and get good margins, you can actually get quite close to the returns that equity has given you historically," says Blayney.
These kinds of investigations are not just theoretical musings. Perpetual is in the early stages of considering a new-style fund that reduces exposure to equities while still delivering the kinds of returns as equity-heavy portfolios.
But it is not as simple as turning to the bond market to deliver those returns.
There has been something of a bond bull market recently as investors seek safety.
When investors are prepared to pay more for a bond, the yield goes down. This has happened with US treasuries, with 10-year bonds now paying about 2.5 per cent.
"It's not going to be government bonds that are going to deliver the return objectives that people need," Blayney says.
Schneider has his own views about just how safe long-term bonds are in a period of increased volatility.
He writes in this week's note: " we believe structural global risks are increasing, not decreasing.
"Accordingly, we believe capital protection is of even greater importance than it was in 2008, if that is possible."
In the interview he says: "In a highly interconnected, highly leveraged world, not much has to go wrong to cause what can be seen as unfathomable results."
