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The Equity Gilt Study has been published continuously since 1956, providing data, analysis and commentary on long-term asset returns in the UK and US. This publication provides a uniquely long and consistent database: the UK database goes back to 1899, while the US data – provided by the Centre for Research in Security Prices at the University of Chicago – begins in 1925.
The Equity Gilt Study is also noteworthy for its focus on long-term market trends. Chapter 1 investigates the unusually high equity risk premia that have been prevalent for the past decade, and that have become more pronounced over the past year. We find that they reflect unusually low risk-free bond yields – which have become negative in inflation-adjusted terms in most developed countries – rather than extraordinarily low equity valuations. It seems that an important cause of these low yields is a scarcity in risk-free assets that is not likely to be reversed any time soon. While positive outcomes such as a stronger economic recovery and a restoration of confidence in euro area sovereign debt would lift equity prices and reduce equity risk premia, risk-free yields are likely to remain low and equity premia high relative to historic norms for a number of years. In Chapter 2, we address the vulnerability of the US, UK and Japan to contagion from the euro area debt crisis. The debt and deficits of these countries are of similar magnitude to euro area countries such as Spain and Italy. However, the US, UK and Japan enjoy institutional advantages such as monetary sovereignty, flexible exchange rates and reserve currency status that offer a degree of insulation from the corrosive market dynamics that we have seen play out in the euro area. That said, th ese institutional advantages merely buy time, and all three countries will have to take significant action to restore fiscal sustainability over the next decade or face adverse economic and market consequences. Chapter 3 takes a close look at the evolution of the Chinese economy. We do not foresee a hard landing, but instead project a gradual shift toward a slower, more sustainable growth rate that de-emphasizes trade, construction and investment and instead places a greater weight on consumer spending as a source of growth. Against the background of increased risk premia and a shrinking supply of perceived safe assets, Chapter 4 considers investment strategies intended to provide protection and preserve capital in a heightened risk environment.
We use this opportunity also to focus our essays on longer-term issues. Chapter 1 makes the case that current policy settings are extraordinarily easy and, if left in place for too long, will result in destabilizing imbalances and stretched asset valuations. The focus of policymakers on short-term results suggests that markets and economies are likely to continue to exhibit a high degree of volatility, reminiscent more of the 1970s and 2000s than the 1980s or 1990s. In Chapter 2, we focus on emerging markets as an asset class, and assess whether the outperformance of returns relative to developed markets seen in the last decade can reasonably be expected to continue. A thorough investigation of the fundamentals suggests that the answer is yes, although the bulk of this outperformance is expected to occur in equities. We also present an independent rating of EM risk by country and region. Chapter 3 examines commodity prices and inflation, and concludes that the disinflationary impact of low cost producers such as China and India is transitioning into an inflationary influence. As a result, the disinflationary trend of the past 30 or so years appears to be turning. Chapter 4 considers optimal investment strategies in a more volatile investment climate – a natural follow-up to Chapter 1. The recommended approach does not require investors to time cyclical inflexion points and allows them to tailor their portfolios to their appetite for risk. Chapter 5 re-examines the influence of demographics on asset returns that has been a theme in previous issues of the Equity Gilt Study. Using more robust testing methods, it re-affirms that ag ing populations are likely to lower returns on both equities and debt, and that equities are still likely to outperform bonds over the next decade, although less so than we had previously thought.
Chapter 1 – From feast to famine
We show how recent financial market crises were in large part a product of changes in global savings flows. An abundance of global savings weakened the collective discrimination of risk and reward in investment, resulting in serial misallocations of savings and asset bubbles. Demographic trends suggest that the world is moving past the high-water mark for abundant savings. Although the frequency of bubbles might therefore decline, we highlight how the same trend will increase risk premia, particularly for bonds, in the decade ahead. We outline some reasons why equities are likely to earn an above-average risk premium over government bond investments in the next 10 years.
Chapter 2 – Bubble identification and some implications
In this chapter, we examine two ways in which asset price bubbles can be identified. Policymakers are now taking a much greater interest in stopping such bubbles materialising in the first place. However, unless they suddenly become extraordinarily successful in doing this, investors who help eradicate bubbles once they have appeared, by tilting their portfolios along the lines that we suggest, should manage to tap a decent source of alpha.
Chapter 3 – Dissecting recoveries
The past decade has provided investors with the rollercoaster ride of two equity market crashes and one of the sharpest global recessions in history. Fears that the 60% rally in equities may have finally drawn to a close have shifted investor focus toward the nature of recoveries. In this article we analyse the speed and duration of previous financial recoveries and examine the key drivers that have helped fuel or stall the rally. We find that historically equity rallies have not necessarily been sustained by economic growth and profitability, but monetary policy and credit conditions. We question whether a clearer understanding of the credit cycle can shed light on the timing of financial turning points.