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Barclays Capital Equity-Gilt Study 2005

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The 50th Annual Equity Gilt Study from Barclays Capital

The Equity Gilt Study has been published annually since 1956. The study provides data and analysis of the annual returns in equities, government bonds and cash from the end of 1899 for the UK, and from the end of 1925 for the US. The US data is kindly provided by the Center for Research in Security Prices at the University of Chicago Graduate School of Business. Shorter histories of UK data are also presented for index-linked gilts and corporate bonds.   

The study say that looking at real investment returns by asset class, equities continued to rally during 2004, growing 8.8% in real terms. Gilt returns bounced back in 2004 from the negative real returns of the previous year. This is a relatively strong performance given that the Bank of England began the tightening cycle in the fourth quarter of 2003, hiking 125 bp by August 2004. Inflation-linked gilts outperformed nominal gilts for the second consecutive year, posting real returns of 4.9%, indicating that investors continued to seek inflation protection.

Corporate bonds returns, at 3.3%, are significantly weaker than the 10-year average. Recent years have seen annual real returns around 6%; however, these supernormal returns and the outperformance versus gilts were due to a period of significant spread tightening.

Real Investment Returns by Asset Class (% pa)
Last 2004 10 years 20 years 50 years 105 years*
Equities 8.8 5.0 7.2 6.3 5.1
Gilts 3.6 6.5 6.1 1.7 1.1
Corporate Bonds 3.3 8.5      
Index-Linked 4.9 5.3 4.1    
Cash 1.1 3.0 4.2 1.9 1.0
Note: * entire sample
Source: Barclays Capital.

Chapter 1: The death of equities?

•  Modern financial theory is placing a much greater emphasis on asset liability matching. As a result, defined benefit pension funds and some insurance companies have been eschewing equity investment in favour of bonds.
•  The post-bubble regulatory environment has eliminated the ability of defined benefit and insurance funds to “ignore” short-term equity volatility in favour of the long-run positive return.
•  Market flows associated with these changing regulations have depressed long-term real and nominal yields, while cheapening equities relative to bonds.
•  We recalculate real asset returns over differing holding periods and examine the distribution of inflation.
•  We find that the risk of experiencing positive inflation grows over time, although the risk of extreme deflation and inflation falls with time. For long-term investors, inflation is the main risk. Equities have offered the most effective hedge against inflation over periods of 23 years and longer, while commodities and property are effective at 10-20 year horizons. For horizon shorter the 10 years, inflation-linked bonds are the superior hedge.
•  Holdings of nominal bonds should increase as liabilities decrease in maturity, but only to hedge potential deflation risk. The bulk of bond investment should be in index-linked paper.

Chapter 2: Dismal demographics

•  Impending demographic change, in the shape of the aging of the “boomer” generation, presents society with the need to manage an intergenerational income transfer.
•  Most industrialised economies have opted, at least in part, to employ financial assets as the token or mechanism for conducting this transfer.
•  Due to the unusual bunching of demographic change as the boomers move en masse into retirement, the fallacy of composites may present a risk to the strategy of using financial assets to fund retirement: a strategy that makes sense for the individual may be counter-productive if employed by larger numbers.
•  We investigate the relationship between past demographic changes and movements in financial asset prices and yields.
•  We find empirical evidence supporting the Friedman/Modigliani lifecycle hypothesis. The relative size of the high savings age cohort is negatively correlated with yields, while the high-debtor age group is positively correlated with yields. The retired cohort is negatively correlated with real equity prices and P/E ratios.
•  These links suggest that inflation has important demographic components.
•  Extrapolating these relationships over the next 20 years suggests that past long-run average returns data will not provide a good guide to future returns, which will be lower than the historical averages.
•  The boomer generation, in competing with one another to buy financial assets, appears to have inflated asset prices and thereby depressed future total returns. Over the past 20 years they have had the opposite effect on the prices of goods and services.
•  As the boomers move into retirement, the relative rates of inflation for financial assets and goods and services will reverse trends, the former disinflating and the latter inflating.
•  The implication is that governments should not rely on managing demographic change by placing progressively greater reliance on funding retirement via financial asset saving. A mixed system that includes an increase in future government borrowing and increased taxation is less risky than a system that relies exclusively on funded pensions.

Chapter 3: Europe’s age-old problem

•  Europe is getting older. By 2030, the proportion of the population aged over 65 begins to edge toward 30% and the total dependency ratio rises up over 80%. Traditionally, the state has provided retirement income but with the increase in the elderly population, the fiscal burden becomes unsupportable. European countries must begin to encourage greater long-term savings through private sector intermediaries.
•  To that end, the EU’s Pensions Directive and Solvency II project offer the regulatory framework that pension funds and insurance companies will need to comply with. The nature of the legislation is such that we believe European institutional investors will quickly pick up the asset and liability management habit that we have seen in the UK. We also think that European debt managers will increasingly look to issue more inflation-linked and long maturity debt in order to provide its savings industry with liability matching instruments.
•  One of the key themes that we have highlighted in our research is the influence of regulation on the investment behaviour of the largest institutional investors. We have noted that a confluence of regulation (FRS17 in the UK, IAS19 in wider Europe and the FTK in the Netherlands) has pushed institutional investors in one direction: longer down the curve. If we add in Europe’s demographics and the desire to move the burden of provision from the state to the private sector, we see a scenario where the demand for liability matching instruments will increase as private pension funds increasingly take on the burden of providing pensions to the population.

Chapter 4: Stocks, Bonds… or Art?

•  The financial setbacks of recent years have left many pension funds in a difficult position. Portfolios overly concentrated in equities, the simultaneous fall in bond yields, and legislative changes have all placed pension schemes under tremendous pressure.
•  The key issues for pension fund portfolios going forward are firstly, diversification of the asset mix and secondly, protection against inflation in order to match future real liabilities.
•  We examine a range of assets and test the performance over different business cycle conditions with particular focus on the ability to act as a hedge against inflation.
•  We include art within the portfolio and test its performance as a diversifier as well as the ability to act as an inflation hedge.
•  Finally, we test for the best mix of assets over different time horizons. Given that different assets provide different grades of inflation protection, it is likely that the asset mix which best suits a pension scheme with 5 years to retirement is likely to be different from one with 10 or 20 years.

Chapter 5: Emerging Markets

•  Sovereign emerging market debt has performed very well in recent times on the back of improving fundamentals, financial deepening and the low global yield environment. Since 1996, emerging market external debt has returned 11.6% per annum compared to a 6.5% return on global equities. The growing interest in this asset class necessitates a closer scrutiny of what type of contribution it can make in a generalist global portfolio.
•  We find that the inclusion of the emerging market debt in a global portfolio increases returns for a given level of risk. Based on the risk-return profile that emerging market sovereign bonds have exhibited since 1996, the asset class demands serious consideration in the investment decision process.
•  Domestic emerging market debt has displayed solid returns in dollar terms; enough to justify global portfolio's considering this type of asset as well. The development of the local market debt is encouraging increased exposure, especially as credit spreads narrow to historically tight levels, as they are doing now.
•  Performance on the local market debt has varied between regions, which highlights the importance of taking into account heterogeneity among emerging market countries. On a risk-adjusted basis, emerging Europe posted the largest gain, followed by Latin America and South Africa.

Chapter 6: Commodities: The case for investment still holds

•  Commodities have been one of the outstanding investments of the past five years. Despite prices that are now trading at multi-year highs in many markets and a big inflow of investment money into the sector, we believe the case for investing in commodities still holds.
•  Over the long term, commodity investment returns compare favourably with those of long-term equity market returns and recent academic work supports the view that historically, investing in commodities has been as rewarding as investing in equities.
•  Diversification is a key reason for including commodity assets in a portfolio. Commodity market returns are negatively correlated with those of stocks and bonds, and those negative correlations have tended to be at their strongest during periods of poor equity and bond market performance.
•  Our portfolio analysis shows that the diversification benefits that commodities bring to a mix of assets justify a significant portfolio share. As a general statement, a 10% allocation to commodities is consistent with the historical risk/reward characteristics of the asset class.
•  The appetite for investing in commodities continues to grow. In a survey carried out at a Barclays Capital conference of pension funds, private banks and hedge funds, 67% of them had no exposure to commodities in their portfolios in 2004, but only 11% felt that their exposure would remain at zero over the next three years.
•  There is still upside to commodity prices in a number of sectors and we expect the roll yield in oil markets to turn positive again in 2005. However the upward path for commodity total return indices seen over the past four years is now moderating and a passive investment in a commodity index may no longer be the appropriate structure for all investors.
•  This does not mean the opportunity for institutional investors to invest in commodities has passed. Investment choices for investors to obtain commodities exposure are growing rapidly, and there are many different ways in which to take advantage of the benefits of commodities as an asset class.

Chapter 7: UK asset returns since 1899

•  Equities continued to rally during 2004, growing 8.8% in real terms. The returns were only half those seen in 2003. However, by historical standards, for example compared to the 10-year and 105-year averages, 2004 was a strong year.
•  Gilt returns bounced back in 2004 from the negative real returns of the previous year. This was a relatively strong performance given that the MPC began the tightening cycle in the fourth quarter of 2003, hiking 125 bp by August 2004.
•  Inflation-linked gilts outperformed nominal gilts for the second year running, posting real returns of 4.9%, indicating that investors continued to seek inflation protection.
•  The importance of dividend reinvestment is highlighted. The value of 100 invested in equities at the end of 1899 was worth just 170 in real terms at the end of 2004, but with income reinvested, the portfolio would have grown to 18,875.

Chapter 8: US asset returns

•  US equities outperformed bonds and cash in 2004, returning 9.3% in real terms – weaker than the performance seen in the previous year, but still strong by historical standards.
•  Cash was the worst-performer of the three assets in 2004, with returns falling 2.4% in real terms, the third consecutive year to post negative returns.
•  The 10-year annualised excess return of equities over bonds currently stands at 2.5%, bouncing back from a 24-year low of -0.6% at the end of 2002.

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