Just last week, a fellow investment professional visiting my office asked me whether stocks would do better than bonds in the next decade, given that they had delivered worse returns than bonds in the previous 10 years. Knowing the risks that forecasting the future carries for the personal reputation of economists and investment strategists, I should have avoided giving a direct answer.
Nonetheless, I stuck my neck out to venture a forecast, and the answer was that at least for the next half a decade, if not longer, the relative inferior performance of stocks versus bonds would continue.
Until recently, it was felt that globalization had enabled the world to break the speed limit on non-inflationary growth. But now it is clear that the impressive growth rates achieved in the period between 2002 and 2007 was more due to the global explosion in debt rather than globalization. If anything, globalization had contributed more to global debt growth rather than to economic growth. Globalization largely rendered domestic capacity constraints redundant. Thus, price increases remained quiescent. That allowed interest rates to remain lower than they otherwise would have. Rapid rise in the use of debt in all forms was the result. For a while, it boosted economic growth and, subsequently, it resulted in the crisis. Such is the intrinsic nature of debt.
Debt elevates growth rates, but for it to be serviced, it also requires growth rates to remain elevated. That is how all Ponzi schemes work. Since maintaining high growth rates eventually would run into resource constraints even in a globalized world, it is simply infeasible. The process of deleveraging has to begin, and it has. It has to run its course.
Consequently, in the next few years, nominal economic growth would thus be lower. The deployment of low interest rates—justified by policymakers in the light of low growth and low inflation—might temporarily boost asset prices again as is happening now, but it also shortens the cycle time between booms, bubbles and busts. Thus, while there are bursts of spectacular returns, those returns are ultimately unsustainable. That is why, far from being a long-term investment option, debt-fuelled growth has made stock market investing a short-term activity. Stocks markets are now casinos.
Statistics tell their own story and do not need any embellishment. In the last 10 years, the average annual total return from S&P 500 stocks is -1%. If we expand the universe to Russell 3000 large cap stocks, the annual average return is -0.10%. The Bloomberg/Effa US government bond return (across all maturities) is 6.3%. Data for the bond return index goes only as far back as 1992. Hence, the annual average returns over the last 17-plus years for S&P 500, for Russell 3000 stocks and for the bond index are 7.3%, 5.4% and 6.5%, respectively.
That is why the obsession with stocks that all market participants, vendors and commentators suffer from is wholly misdirected. Further, that is why the piece by Richard Bernstein, former North American investment strategist for Merrill Lynch, published in the Financial Times last week, is a “must-read” for investors for whom investing is a serious exercise. He points to the negative correlation of bond returns with stock returns and hence, having government bonds as part of one’s investment portfolio enhances its returns and reduces portfolio return variability.
Correlation within the equity asset class across geographies makes all talk of diversification into emerging markets essentially meaningless. It is a chimera. Stocks in emerging markets are mostly testosterone enhanced versions of developed country stocks. The annual average return in dollars from the Morgan Stanley Capital International (MSCI) Asian stock index (excluding Japan) in the last 10 years was 4.88% and in the last 20 years 5.74%. That exposes the limitations of the Asian miracle.
In India, the story is not much different on closer examination. Annual average return (in dollars) on the MSCI India stock index over the last 16-plus years has been 8.9%. That sounds higher than any of the numbers we have seen earlier, but in (nearly) 10 years starting from 1993 and ending in September 2002, the average return was -2.6%.
So the gains were made almost entirely in the five years starting October 2002, when the global interest rate regime was too liberal. In theory, emerging economies such as India would enjoy higher nominal gross domestic product growth than developed countries. That boosts top-line growth for companies. However, the valuation premium that investors would be willing to offer for such higher top-line growth would depend on other factors.
In sum, for the next half a decade or longer, stocks in the developed world are more likely to perform poorly compared with bonds. The tight correlation of emerging market stock returns with that of developed world stocks exposes them to the same risk of underperformance.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org