Stock Market investors have had a frustrating decade, with developed market equities underperforming government bond markets and equities scarcely making money on an absolute basis, even before allowing for inflation.
This pattern was seen in most developed stock markets. That £1 invested on December 31, 1999, when the FTSE 100 reached its all-time high of 6,930, was worth just 75p at the end of November of this year. The return rises to £1.04 if dividends were re-invested.
Meanwhile, investing in Gordon Brown would, perhaps surprisingly from today’s point of view, have been better than investing in the real economy with a return from gilts of 40 per cent.
No doubt some of this gain is thanks to the emergence of the largest gilt-buyer ever: quantitative easing but the real driver for bond growth has been the flood of pension-fund money as trustees have been forced to cover long-term liabilities with low-risk investments. This process has also reduced the activity levels of some of the biggest equity buyers in the market.
If the financial markets do indeed work to the cycle of fear and greed, the last decade can be described in terms of fear, greed and fear again. First fear as the dotcom bubble burst, contributing to plunging of share prices until March 2003. Enron and other corporate scandals highlighted the excesses of the previous decade, followed by lengthy jail sentences for some top executives.
Then cheap and plentiful credit began to lift all boats once more, as the global economy went on to enjoy its strongest GDP growth since the Second World War from 2004 to 2007 and US corporates their longest period of successive quarter-on-quarter profits growth.
The effects on the financial markets of low interest rates from 2001-2005, with product innovation by the financial sector, was astonishing. Financial institutions were able to offer complex packages of high-risk assets, which might have been geared at various levels, to investors who were searching for the higher yield they offered because their bank account or government bond returns were so meagre.
It was not just buyers and creators of financial assets that borrowed excessively in their belief that a brave new world of high debt levels could be sustained. Households reached record levels of borrowing in the US and the UK, fuelling house-price inflation. Meanwhile, in the UK, then-Chancellor Gordon Brown oversaw the emergence of what has become a serious budget-deficit problem as he borrowed to pay for greater public spending.
Stock markets boomed, particularly the emerging markets which were supported by strong underlying GDP and profits growth. By sector, natural resources outperformed on the main markets as tight demand and supply characteristics came to the fore. In the UK, mid-cap stocks outperformed, thanks in part to takeover activity as continental companies looked to grow in the UK.
A new period of fear emerged slowly in 2007, even as stock markets reached their cyclical highs. As the US property cycle began to weaken, fraud was uncovered in the mortgage market.
As defaults rose, particularly in sub-prime mortgages, owners of financial products that contained the debt found that there was no-one to sell
them on to. Rising interest rates induced a slowdown in the business cycle, compounding the problems of a deflating property bubble in many economies.
It was found that during periods of stress, a diversified portfolio of risk assets did not necessarily offer protection, contrary to many investors’ prior assumption. Furthermore, the US authorities challenged the presumption that the larger banks would not be allowed to fail, no matter how weak their balance sheet may be.
In September 2008, Lehman Brothers was allowed to collapse, triggering fears of a systemic banking collapse and a global depression.
Stock markets lurched. Very large injections of public funds into the global banking system and into fiscal stimulus programmes and the creation of large quantities of very cheap money by central banks, finally allowed confidence in the global economy to stabilise.
Stock markets began what was to be a powerful recovery rally in March 2009 that lasted into the winter but the decade ended with many of the problems that caused the bear market still with us, namely excessive amounts of debt.
Large quantities of bank debt have been nationalised, adding to government budget deficits that are in any case straining from a collapse in tax revenue and an increase in welfare payments. Meanwhile, British households remain over-borrowed by historical standards.
So what of the coming decade? It seems inconceivable that financial markets will be able to return to the levels of risk-taking that were common in the mid-2000s. However, there has been little real movement from world leaders to regulate against the worst excesses.
At the same time, bankers appear to be showing little contrition or much change in how they do business.
I don’t think it takes a genius to see that there will be another serious financial crisis in the coming decade. It will probably be caused by a trading system or financial instrument about which we know nothing at the moment. A more serious issue may come from a major currency crisis or the de-rating of a large Western economy.
However, it won’t be all doom and gloom for the investor. Demand in the west may remain sluggish for a few years, but there is no reason to think that the likes of China, India and Brazil will not continue to grow strongly over the next ten years.
Although there may be a fair amount of volatility, investments in these areas are likely to outperform Western markets. Having said that, if you invest in western companies with strong export links to these areas, you are likely to do well.
Away from equities, one area which may well see steady returns over the next four or five years is commercial property, basically because prices fell so dramatically from mid-2007.
The benefits of a diversified investment portfolio may not have been apparent over the last ten years, but it still would have protected you from the worst of the stock market falls.
Going forward, it will still pay to diversify, but that will mean diversifying into the rapidly emerging economies of Asia and South America as well as across asset types.
* Trevor Law is a director with Montpelier Group (Europe) Ltd, the privately-owned independent financial advisers located near Solihull. E-mail: tilaw@montpeliergroup.com
