UK/US EQUITY -  STOCKS & GILTS RETURNS STUDY 2007

Barclays Capital Equity Gilt Study 2007 is the 52nd annual edition of Barclays Capital's flagship publication and is one of the oldest and most respected continually published research document in the City.

Since 1956, the Study has provided investors with reliable long term data series for nominal and real returns from UK and US financial assets. The UK data series begins in 1899 whilst the US series starts in 1926. "Aside from the historical data presented in the Study, Barclays Capital also addresses various topics that are of relevance to the long term investor or asset allocator" said Tim Bond, Head of Global Asset Allocation Strategy and the primary author of The Equity Gilt Study. "Whilst most financial analysis is generally focussed on the short term, the long historical horizon of the Equity Gilt Study provides an appropriate setting to consider broader issues that are often neglected by the markets."

Equity yields

Climate change will boost the global economy and dominate financial markets over the next 25 years, a leading investment bank has predicted.

In this years report, Barclays Capital challenges the conventional wisdom that global warming will have a devastating impact on economic growth. It believes the need to increase energy capacity by 50 per cent by 2035, while simultaneously reducing dependence on hydrocarbons, will spark an " energy revolution" reminiscent of the technology revolution which led to the dot.com boom.

"If ever the time were ripe for such an energy revolution, it is now," said Tim Bond. "And like all historical adoptions of general purpose technologies, the process should prove immensely stimulative to economic growth."

Bond says that those who couch the climate change debate in terms of the cost to growth are underestimating the impact of an energy revolution. Last year's Stern Review concluded that if temperatures rise by five degrees celsius, up to 10 per cent of global output could be lost.

"All of the historical changes in energy supply - from dung to wood to coal to oil - were stimulative for the economy concerned. Every major technological change was accompanied or followed by faster economic growth." he said. Like every revolution, there will be winners and losers, with the energy sector set to reap the biggest rewards.

In the meantime, current uncertainty over US climate change policy may be deterring energy investment, the report says. Until public opinion forces the US administration to address the issue, energy scarcity will intensify and prices will continue to soar. Indeed, futures markets suggest that oil prices, already at levels last seen during the 1970s oil shock in inflation-adjusted terms, will keep rising due to a worsening supply/demand imbalance. The same is true for the other hydrocarbon, coal.

"The impact of the replacement, restructuring and expansion of our energy infrastructure cannot be ignored," Bond said. "Just as the personal computer cannot be un-invented, neither can the impending energy revolution."

The report is contained in Barclays Capital's annual Equity Gilt Study, which shows that equities were far and away the best-performing financial asset in 2006, as the stock market rally continued. Last year, money invested in stocks and shares grew by 11.4 per cent, still less than the 19 per cent growth seen in 2005.

In contrast, money invested in gilts shrank by 4.4 per cent as rising inflation wiped out nominal returns. Corporate and index-link bonds also suffered, falling by 4.5 per cent and 2.1 per cent respectively. Cash returns edged up by 0.4 per cent.

Barclays Capital calculated than an investor who put £100 in the stock market in 1899 would now be sitting on £25,022 if all income had been reinvested and adjusted for inflation. The same money invested in gilts would now be worth £323. If the £100 had been kept in cash, it would have swelled to just £286, it said.  

The Equity Gilt Study
The Equity Gilt Study has been published annually since 1956. The 2007 Equity Gilt Study is the 52nd annual edition of Barclays Capital’s flagship publication. 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 highlights of the 2007 edition of the Equity Gilt Study as summarised by Barclays, are presented below in chapter order.

Chapter 1 – The energy revolution
We examine the relationship between the energy market and climate change policy. Our thesis is that the energy infrastructure of the global economy is prone to radical restructuring in the years ahead, a process that could be described as an energy revolution.

The driving forces are twofold. First, the spiral higher in energy prices since 2002 has revealed that current energy supply is likely to prove insufficient in light of current demand trends. The world therefore needs a sizeable increase in capacity to accommodate the energy ambitions of both industrialised and industrialising economies. Second, public opinion in the OECD has reached an inflection point on climate change, with the political path now open for establishing an international agreement on emissions reduction.

We discuss the difficulty of simultaneously increasing energy supply by 50% over the next 25 years, while also lowering dependency on hydrocarbons, which currently provide 80% of the world’s energy needs. The likely effects on asset markets and modes of financing are expected to be sizeable and could dominate other fundamental factors. Investors need to place the nexus of climate change policies and energy scarcity at the centre of their asset allocation process. We conclude that the impending energy revolution may – contrary to consensus expectations – prove highly stimulatory for the global economy.

Chapter 2 – Monkey business
Equity yields have remained at high levels relative to other asset classes for the fourth consecutive year. We consider the causes of these comparatively high equity yields and find a relationship between past equity volatility and the forward-looking equity risk premium. We show how the earnings yield ratio on equities is an effective predictor of the subsequent realised equity risk premium and use this methodology to forecast above-average equity returns in European and UK markets over the next decade. We discuss whether it is possible to hedge out equity risk and conclude that doing so tends to hedge out the excess returns as well. Ironically, the distortion to equity volatility markets caused by investors seeking to limit equity risk offers opportunities for tactical relative value trades that can potentially offset actual equity volatility.

Chapter 3 – The return of diversification
This essay is a contribution from Barclays Global Investors (BGI) research, describing how investors can make use of the increasingly wide range of markets and instruments available to build better portfolios. Markets have developed to the point where it is now much easier and cheaper to access more precise risk exposures. While this is of course a great boon, the task of aggregating these risks into a diversified portfolio is now more complex for the end investor.

The theoretical framework for building a diversified portfolio dates back to the work of Markowitz and Sharpe in the 1950s, but the practical implementation has been fraught with difficulty. Correlations are notoriously unstable and indeed tend to increase when times are bad. Furthermore, estimating future returns from past performance requires more than clever statistics: financial and economic reasoning is needed to build appropriate models and thus create optimal portfolios. The article describes how the best answer need not be the classical “market weighted” portfolio, and outlines techniques by which investors’ aversions to poor returns can be accommodated within the portfolio construction process

Chapter 4 – Send in the clones
We continue last year’s theme of decomposing hedge fund returns. The cases for and against hedge fund replication models have been heavily debated over the past year. Following poor hedge fund performance in the wake of the May 2006 equity market sell-off, there have been increased concerns over whether hedge fund returns were predominantly market-dependent or due to manager skill. Numerous attempts have been made to replicate hedge fund returns, and market commentators predict a proliferation of investable synthetic hedge fund products. These synthetics may provide a cheaper alternative to the “2 and 20” fee structure often charged by hedge funds. However, there remains the risk that synthetic models will be unable to protect the investor from extreme downside risks, while a skilled manager may be more able to navigate the financial markets during turbulent periods. We examine an alternative approach to replicating hedge funds, which provides a forward-looking view of different asset classes, as well as a stop-loss mechanism to protect an investor when markets are hit by extreme events.

Chapter 5 – The state that I am in…
Our final essay celebrates, if that is the right word, the tenth anniversary of the shortlived MFR. It has been 10 years since the introduction of the Minimum Funding Requirement and the abolition of Advanced Corporation Tax relief. Since then, the “pensions crisis” has rarely been far from the headlines. It has prompted a comprehensive overhaul of the regulatory framework and there have been changes to accounting regulations in an attempt to shed some light on the “black hole” at the heart of corporate balance sheets. The growth of “liability driven investment” (LDI) strategies has increased the use of equity and fixed income derivatives to help manage exposure to both equity and interest rate risk by the construction of hedging portfolios. We review some of the main features of the changed pension landscape and consider the future.

Chapters 6 and 7 – Asset returns
We publish last year’s US and UK asset returns, placing them within a historical context. Broadly, equities strongly outperformed bonds and index-linked securities, which posted negative returns. UK gilts and index-linked markets performed very poorly in 2006, both ending up in the eight-worst historical deciles, while equity returns were far above the long-run average. UK equities returned 11.4% after inflation, against minus 4.4% for gilts, minus 2.1% for index-linked and 0.4% from cash. The average UK equity outperformance over gilts (the equity risk premium) during the past 107 years is now 4.2%, an increase of 0.2% from last year’s calculation. US equities and bonds performed in a similar manner to the UK markets, with equities posting above-average returns while bonds did very poorly. Adjusted for inflation, equities returned 13.3%, Treasuries minus 1.2% and index-linked Treasuries minus 4.6% after inflation. On the back of higher policy rates, cash returned 2.2%.

To obtain a hardcopy of the Equity Gilt Study, please email equitygiltstudy@barclayscapital.com

 

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