Global Economy
Barclays' study warns of increasing market volatility; Rising inflation in China/ India marks end of 30-year global disinflationary trend
By Finfacts Team
Feb 14, 2011 - 4:29 AM

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Barclays Capital warns in the 56th edition of its annual research publication, the Barclays Equity Gilt Study 2011, which was published last week in London, that the current focus of policymakers on short-term results suggests that markets and economies are likely to continue to exhibit a high degree of volatility, reminiscent more of the 1970s and 2000s than the 1980s or 1990s.  The recent impact of rapid commodity price rises on inflation is covered in the study, which makes the case that the disinflationary impact of low cost producers such as China and India is transitioning into an inflationary influence. As a result, the global disinflationary trend of the past 30 or so years appears to be turning.

Investment returns in the last decade were the worst since the 1970s with real returns from equities a near-negligible 0.6% annually in the period.

Holding cash delivered almost twice as much, 1.1%  a year, while government bonds or gilts produced return of 2.4% a year.

Since World War II, only in the 1970s were inflation-adjusted returns worse, at an annualised 0.4%.

The study says current policy settings are extraordinarily easy and, if left in place for too long, will result in destabilizing imbalances and stretched asset valuations.

Piero Ghezzi, head of research in Economics and Emerging markets at Barclays Capital and co-author of the study, said last week that there has always been a higher growth in emerging markets than in developed markets but what has changed is the volatility in these markets driven by high inflationary policies. With equity returns in emerging markets likely to outperform those of developed markets, he said that emerging markets economies are maintaining policies too loose for their cyclical position.

Amrita Sen, head of Commodities research at Barclays Capital said the shift in the balance of economic power underlines the resurgence of a historic shift in wealth creation from West to East, bringing profound changes to the economic and financial landscape.

“The higher demand for investment in emerging markets themes is heavily reliant on commodities,” said Sen. She expects  resource scarcity would continue to be a dominant theme in the future while the disinflationary impact of low cost producers such as China and India is transitioning into an inflationary influence. The sharp rise in the prices of raw materials which, along with other factors, suggest that the “30-year trend of disinflation is ending.”

“The Equity Gilt Study offers a unique opportunity for in-depth analysis of medium-term issues confronting investors,” said Larry Kantor, head of research at Barclays Capital. “The extraordinarily easy policies put in place during the crisis are providing a significant lift to financial markets, but at the same time they signal important risks beyond the near term. In the meantime, investors should continue to focus more attention on selected emerging markets, where risk-return trade-offs are likely to continue to be more attractive than for developed markets.”

Major themes of the Barclays Equity Gilt Study 2011 include:

  • There are significant risks associated with leaving extremely expansionary policies in place for too long;
  • Emerging market economies are set to continue to deliver higher growth and lower volatility than developed markets, which should translate into outperformance in emerging market equities. Emerging market debt, by contrast, has been largely re-priced, and excess returns are likely to be much smaller over the next decade;
  • The impressive growth of China and India is increasing demand for commodities at a rapid pace, making it difficult for technological advances to allow production to catch up with demand;
  • Optimizing investment strategies for a more volatile investment climate;
  • Ageing populations will reduce both stock and bond returns over time, but the excess return on equities is not as large as previously thought.

£100 invested in shares in 1990 with income reinvested would be worth an inflation adjusted £323 today, compared with an investment in gilts which would have produced £311 over the same period.

However, since 1899, shares have produced a real annual return of 5.1%, compared with 1.2% for gilts.

A hard copy of the study is available for £100.

UK real asset class returns (% per annum)

  2009 10 years 20 years 50 years 110 years
Equities (shares) 25.9 -1.2 4.6 5.2 5.0
Government bonds (Gilts) -3.3 2.6 5.4 2.3 1.2
Corporate bonds 15.8 2.9      
Index-linked bonds 3.1 1.9 3.8    
Cash -1.7 1.8 3.1 1.9 1.0

Source: Barclays Capital Equity Gilt Study 2010 (Note: Where data is not available, there is a gap).

Chapter 1 - Easy policies today, rude awakening tomorrow
Extraordinarily expansionary policies played a critical role in pulling the world out of the financial crisis and severe recession of 2008-09. However, there are significant risks associated with leaving extremely expansionary policies in place for too long. Such policies, if not removed, are likely to cause significant economic imbalances and asset mispricing, making markets excessively vulnerable to damaging corrections and leaving economies with limited ability to cope with future shocks. This would not be the first time that policy has been too easy: in the 1970s, and again in the past decade, easy monetary policies left in place for too long led first to market instability and then to economic volatility. This time, the situation is exacerbated by overextended fiscal policies.

Chapter 2 - Navigating the new EM landscape: Where to find the best returns
In the six years since this series last took up emerging markets, much has changed. Global influence has moved from the slow-growing G7 to booming China, contributing to EM growth outperformance. EM also weathered the 2008 credit crisis remarkably well, despite some initial scepticism, due predominantly to robust policy frameworks tempered in earlier booms and busts. We think investors should expect EM economies to deliver higher growth and lower volatility than in the past, improving economic Sharpe ratios relative to the lagging G4. Although EM growth outperformance is part of the received market wisdom, we think it is not fully priced in to today’s equity markets. We forecast EM equity market returns of more than 10% (in USD, adjusted for US inflation), in line with the past decade’s strong performance.

Chapter 3 - A return to scarcity: The disinflation trend is over
Over the past decades, globalization has brought sleeping giants to the global goods and labor market. This, coupled with technological advances in commodity production, helped generate disinflationary pressures globally. However, the impressive growth of China and India is increasing demand for commodities at a rapid pace, making it difficult for technological advances to allow production to catch up with demand. This is creating inflationary pressures on commodity prices, making them more vulnerable to shocks and, hence, more volatile. In turn, policymakers face deeper challenges, as central banks of commodity-importing countries have to fight these imported inflationary pressures and respond to more volatile price fluctuations.

Chapter 4 - Simple strategies for extraordinary times
The past decade has been a rollercoaster ride for investors. In the past 12 months alone, investors have been buffeted by deficit concerns in Europe, deflationary fears in the US, and, most recently, expectations of rising inflationary pressures. Furthermore, the response from policymakers has been unprecedented, with central banks embarking on a mission to ease monetary policy via quantitative easing and governments under pressure to tighten fiscal policy and tackle growing deficits once and for all. We present simple strategies to help navigate the volatile waters of today's investment environment: by extending the humble diversification process and focusing on risk- rather than return-based allocation strategies, we believe investors can protect portfolio returns without worrying about forecasting future returns or timing the next big correction.

Chapter 5 - Dismal demographics and asset returns revisited
The 2005 edition of the Equity Gilt Study contended that demographics are a powerful driver of medium- to long-term trends in bond and equity markets. In this edition, we reexamine the issue of demographics and asset returns more formally in order to address criticisms of past attempts at quantifying potential linkages between them. We find that demographics matter, though perhaps not quite as much as our earlier work had suggested. Accordingly, our original findings that demographics would reduce both stock and bond returns over the medium- to long-term remain unchanged, and we still expect equities to outperform bonds over the next decade. However, we now conclude that the equity risk premium may be 1% lower than the historical average, whereas we formerly reckoned that it would be 1% higher.

Chapter 6 - UK asset returns since 1899
This chapter presents the real returns of the major asset classes in the UK. Financial markets faced a volatile year in 2010, yet equities managed to end the year in positive territory. The FTSE all share price index had fallen 12% year-to-date by July, but managed to rally 23% for the remainder of the year. Equities were the worst performing asset over the decade, producing a meagre inflation-adjusted return of just 0.6%, although this is a marginal improvement over the negative 10-year returns produced over the past two years. Gilts continued to outperform equities over the 10-year horizon and the annual performance in 2010 was a marked improvement from the negative returns during 2009.

Chapter 7 - US asset returns
This is the 11th year in which we have incorporated US asset return data. US asset returns followed a similar trend to those of the UK. Equities were the best performing asset, despite periods of intense volatility. US equities followed European stocks lower as the sovereign debt crisis unravelled in the spring. The turbulence continued into the summer as weaker domestic economic data triggered fears of a deflationary spiral back into recession. Treasuries and TIPS performed well, as the flight-to-quality trend dominated during the spring and summer months. The Fed’s announcement of a second round of quantitative easing helped fuel a recovery in global equities into year-end. Over the decade, equities underperformed all assets aside from cash.

Chapter 8 - Barclays indices
We have calculated three indices: changes in the capital value of each asset class; changes to income from these investments; and a combined measure of the overall return, on the assumption that all income is reinvested.

Chapter 9 - Total investment returns
Our final chapter presents a series of tables showing the performance of equity and fixedinterest investments over any period of years since December 1899.

Pull outs
The final pullout section provides the annual real rate of return on both UK and US equities and bonds (with reinvestment of income for each year since 1899 for the UK, and 1925 for the US). There is also a table showing the real capital value of equities for the UK. Source for all data in this chapter are the Barclays indices as outlined in chapter 8.

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