By John Wilson

As old certainties disappear, it’s clear that actively managed bonds may be a safer bet than equities. In the deep of our investing hearts, part of us realises that the comfortable certainties of the last 25 years – falling inflation, falling bond yields, rising stock markets and property prices – are gone, replaced by an alien global investment landscape.

 But then again, one might ask why should we believe that things have changed? Markets recovered some lost ground over 2009 and in 2010: isn’t that how it is meant to be? After each market downdraft, there is a rally (something akin to a hangover free morning after the big night before).

Now that the natural order of markets has been restored, there is no need to think of investments differently, right?

The global financial crisis was a one-off event, unlikely to be repeated, an outlier, so called tail event in the lexicon of the statisticians and market strategists. Most certainly not something that should cause us to examine the basis upon which we conduct our overall investment strategy.

It is now not so much the event itself but more the policy response (and the consequences which flow from it) that should grab our attention. Government policy intervention on an unprecedented scale has underpinned a rally in all risk assets. But now, as stimulus fades, and the breadth of the problem in developed economies becomes clearer (Dubai, Iceland, Greece – who is next?) it is highly unlikely that the returns of the recent past can be extrapolated into the future.

What if we viewed the global financial crisis as the penultimate stage of a 20-year period of credit creation? If you think of it that way, one can only wonder at how different equity and bond returns would have been but for the massive credit creation of that same period. Combine the evaporation of that very credit with the “never again” mentality of those regulators who’ve had to deal with the consequences of the GFC and you have a uniform desire for greater regulation and the likely limitation of risk taking behaviour by financial institutions.

Lower levels of leverage within the finance sector means less risk capital (and more expensive credit) right across the economy. In turn that means lower returns from both listed and unlisted equity markets.

If we use finance and banking companies, then you have the problem writ large; investors loved “financials” as management could imbed masses of leverage on their balance sheets and thereby, lever up Return on Equity (RoE). Stocks such as Freddie Mac, Fannie Mae and Citibank became the darlings of equity managers, particularly those employing value strategies.

In retrospect, one must now regard finance stock returns of the last 20 years as bubble returns, unlikely to be repeated, with normalised returns lower into the future, as the leverage that drove RoE in the past is no longer available. So, unless you garner higher returns on equity from other industries (in what is a poor growth world), then it’s likely this factor alone compresses equity returns. Finance stocks comprise 18% of the MSCI World Index and 35% of the ASX 200.

Perhaps it is time to revisit your assumptions about future equity market returns?

Over in the bond market, there is now much more sovereign debt risk than in the past.

Bond market indices are typically market capitalisation weighted, much like equity indices. Capitalisation weighted indices means investing more money in the debt of the more highly indebted nations. When the fundamentals are right, that often isn’t a problem; but at the moment, with government bond yields low and sovereign balance sheets being used to fill the shortfall in economic activity (and many now bloated with debt), the sovereign debt arena is now more fraught than ever. Is the UK the next Greece?

Opportunities abound for nimble active bond managers who are not tied to copying indices, and who can invest across regions, countries, sovereign and other types of debt.

If ever there was a time to think differently about your bond index, favouring markets with lower debt to GDP ratios and embracing active bond management, it’s now.

John Wilson is head of PIMCO Australia

CLICK HERE to read Susan Gosling’s original article

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