More than five years on from one of the largest financial collapses in history, the global economy seems to be in recovery mode.
The US has already begun to reduce its QE, the possible break-up of the eurozone seem to be a thing of the past and Bank of England is considering raising interest rates as soon as 2015.
Throw into the fact that developed equity markets have made huge gains over the last five years and some – such as Old Mutual’s Richard Buxton – have said that this is the start of a structural bull market.
However Harries, who manages the Newton Global Higher Income and deputises on the Newton Real Return fund, and Hensman, who is global strategist at the group, warn that the next 10 years will be turbulent for investors.
Following the 10 year anniversary of the £9bn Real Return fund, they highlight the five major reasons why investors should not get carried away with the strength of the global economic recovery.
Huge amounts of debt
Harries (pictured) says that the vast amount of debt in the global economy is an issue which has been swept under the rug. However, he says as this level of debt is so unprecedented it will ultimately impact on global growth.
“Newton has been talking about debt, and the problems of debt, for more than a decade. It’s noticeable, to me at least, when people start to get bored us talking about it again is the time when it starts to become a problem,” Harries said. “There are those that say debt doesn’t matter. We don’t take that view: we believe that debt is consumption and activity brought forward. If savings is consumption deferred, debt is consumption brought forward. We brought a lot of forward and we can’t do it again.”
He says that back in 2004, when they first launched the Real Return fund, they were concerned that the amount of debt that had been laid onto the economy would eventually cause an issue. However, now he says the problem is far worse.
“In terms of debt burden, we are still talking about it and the only problem is there is now a total of 30 per cent more debt than there was a before the credit crunch,” Harries explained.
“This level of indebtedness is truly extraordinary.”
Poor demographics
The second headwind, according to Harries, is demographics, or aging populations.
He says that as the baby-boomer generation reaches retirement and beyond, it is going to create a real drag on the global economy.
“An ageing population, as we all know, leads to a decline in consumption it leads to it being more difficult to grow, it makes it more difficult to achieve GDP growth and creates a deflationary impulse on asset prices. Demographics, as we thought back in 2004, are becoming more of a problem.”
“Demographics have moved on a decade, but the problem has only really just become more apparent and immediate.”
“More countries now have a population which is going to make it difficult to grow, including countries like China and Russia.”
Starting valuations are already high
According to FE Analytics, the likes of the S&P 500 and FTSE All Share have delivered a return of close to 150 per cent since the market bottomed after the crash in March 2009.
Performance of indices since March 2009
Source: FE Analytics
However, Harries warns that has led to high starting valuations.
“If there is one truism of investment, or one real lesson from history, the thing that drives the return from a financial asset, more than anything else, is what you pay for it. All the rest, in some respects, is mostly detail.”
“Even in 2004 relative to say, 1981 when the last big bull market began, things weren’t looking that great in terms of expected returns.”
“Now we know that valuation alone doesn’t tell you a great deal about what asset prices are going to do over a short period of time, but it is quite robust for looking at what the expected return is likely to be.”
For instance in an article last week, Harries’ colleague – FE Alpha Manager Iain Stewart – said that in 1982 the US Federal Reserve’s funds rate [the interest rate at which US banks lend to each other, equivalent to LIOBOR] was 12 per cent and 10 year US Treasuries were yielding 12 per cent. Now, however, the Fed funds rate is 0.25 per cent and treasuries yield 3 per cent.
He also pointed out that in 1982 the P/E ratio and the cyclically-adjusted P/E ratio of the S&P 500 were 7.7 times and 7.8 times, respectively. Those figures now stand at 18.6 times and 25 times respectively.
Huge distortions in the market
While it is linked to their last point, the Newton team are concerned that the major driver of equity returns over recent years has been due to central bank intervention which has, in turn, caused investors to bid up prices.
“While equity markets have been ascending over the last four years, as you know, earnings really haven’t.”
“What we have seen is a big elevation in valuation, but without a recovery in earnings to justify that move,” Harries said.
“In addition to that, we have seen that cyclically adjusted valuations of equity markets are now trading at the top end of their historic levels.”
“That would suggest to us that asset prices have been elevated, but it also means, of course, that returns from here are likely to be constrained even more so than perhaps they were before.”
In a recent FE Trustnet article, Psigma’s Tom Becket also warned about the recent P/E expansion in developed equity markets, stating that close to three quarters of the S&P 500’s 30 per cent return last year was driven by re-ratings.
Performance of index in 2013
Source: FE Analytics
He warned that, without earnings growth, the chances of developed world equities pushing forward further are very unlikely.
Don’t listen to forecasts
Finally, Peter Hensman says that investors should take bullish economic forecasts with a very large pinch of salt.
“When talking about the prospects for the next 10 years, we are not trying to undertake an attempt at forecasting,” Hensman said.
“The reason why we think that is the correct thing to do is best summed up by a quote from JK Galbraith – “There are two types of forecasters. The ones that don’t know and the ones that don’t know they know”.”
“Of course, sometimes we see forecasters making extraordinarily large errors. One of which is best demonstrated when Dick Fuld, former CEO of Lehman Brothers, as he looked at the world in April 2008, he suggested that “the worst of the crises is behind us”.”
“What we tend to find when people forecast is that they very much talk about what people want to hear as opposed to what it is probable over the period ahead.”
His thoughts are similar to those of FE Alpha Manager Marcus Brookes, who also questions some of the most recent economic and equity market forecasts.
“People are saying “well if you adjust for this and you adjust for that, there are plenty of reasons to be bullish”. Effectively what they are saying is if you ignore all the bad news, then everything looks good,” Brookes said.