Market View - May 2011

Milton Friedman the Nobel Laureate economist famously remarked “Inflation is the one form of taxation that can be imposed without legislation”!

Doubtless Steve Forbes, the well known publisher, had Friedman’s observation in mind when he said at a recent lecture in California “The Federal Reserve has been on a bender since the early part of last decade, printing too much money. They’ve done it again, and while some people may benefit short-term, overall you don’t get productive investment, which means more inflation at home, and speculation in commodities and currencies”

Forbes went on to predict that “within the next five years for the first time since the 1970’s the dollar will be re-linked to gold”. While Western debt continued to dominate financial news last month, thankfully a combination of the hottest April since records began, the latest Easter for decades, and the first royal wedding for a generation gave British investors a much needed feel good factor as recent black swan events receded from the big screen and equity markets (for the most part) soared!

Global markets (MSCI World) remarkably climbed more than 4% in April with the FTSE 100 in the UK up 2.73% and the S&P 500 in the US up 2.85% while in Europe the FTSE EuroTop climbed 3.52%! Emerging markets generally did well too with the MSCI EM index climbing 2.83% although the Chinese (Shanghai Composite down 0.57%) and Indian (MSCI down 1.93%) markets spoilt the party on fears of further interest rate tightening to control inflation.

Meanwhile one of the key messages in this year’s Barclays Equity Gilt study was “Demographics are a powerful driver of medium to long term trends in bond and equity markets”. Research going back more than a century confirms the long running equity risk premium (i.e. the expected annual return from equities over and above risk free government bonds) to be 4%, although this rate increased dramatically to nearer 7% in the forty year period ending in 2007.

Based upon a comprehensive re-evaluation of their past analysis, the Barcap team has revised its previous forecast equity risk premium for the next decade from 5% to 3% but continues to emphasise the influence of demographics upon these returns. Their research looks at trends in three adult categories in the US since 1900, namely the proportion each year of the population aged 25 to 34, aged 35 to 54 (the category most likely to be net savers and investors) and those aged 65 and over (those most likely to be spending their lifetime savings during retirement and consequently more cautious investors).

The three graphs produced by the data are helpfully extended beyond 2010 to 2020 based upon United Nations expectations for US demographic trends, and the most striking aspect of the graph for the 35 to 54 year old section of the population is the way its overall percentage increases consistently from around 20% of the total in 1980 to more than 30% in 2000 before heading lower almost as dramatically over the last decade. Meanwhile the trend for the 65 or older category not surprisingly is almost mirroring the rapid rise of the 35-54 year old section some twenty years later starting around the year 2000 and projected to continue for the next decade.

The correlation between the phenomenal rise in the post World War Two baby boomer savers and the great twenty year Wall Street equity bull market that began in 1981 is clear for all to see. The bad news from the Barcap team is that having built a new demographics enhanced “macro” model of real equity returns in the US, the omens for the future look less good than they did in previous editions of the study!

Of course much has been made in recent years of studies (e.g. Goldman Sachs with their BRICS analysis) showing the positive impact of demography in some of the major emerging economies (albeit for perhaps no more than a decade or two in some countries before they too begin suffering from an excess ratio of retirees to earners like many Western nations) and the likely impact of this upon equity returns. The current edition of the Barclays Capital Equity Gilt study gives lots of other reasons also as to why the next decade is likely to offer attractive opportunities in emerging market equities.

As the Barcap team observed when the latest edition was published in February, “although EM growth outperformance is part of the received market wisdom, we think it is not fully priced in today’s equity markets. We forecast EM equity returns of more than 10% (in USD, adjusted for inflation), in line with the past decade’s strong performance. In absolute and volatility-adjusted terms, the most promising equity markets are those where we expect highest growth; six out of the 10 most promising are in Asia”

While Ash-Ridge Asset Management strongly recommends a reasonable allocation to emerging market equities for the best potential longer term growth opportunities, it is also equities that we prefer for the core of investor portfolios. With the yield on both cash (UK base rate 0.50%) and government securities (Ten Year Bonds: UK 3.39%, US 3.17%, Japan 1.20%, Germany 3.22%, Switzerland 2.03%) at near historical lows, and the relative risk reward on the latter at unattractive levels, higher yielding UK equities (e.g. FTSE UK All Cap 3.00%, FTSE 350 High Yield 4.21%) and selectively other developed market higher yielding equities offer the best risk reward opportunities over the shorter and medium terms.