Here in Northern Europe, the autumn storms have swept through, the days are very short and it is getting steadily colder, with the festive season just around the corner. From an investment perspective, as 2013 draws to a close, it seems an appropriate time to stop and reflect, not only on the past year, but on the wider progress made in rebuilding global economic growth and stability since the great financial crisis (GFC). In our opinion, the economic recovery remains fragile while gaining some momentum in the US in particular, and we see continued low levels of corporate confidence, with governments stymied as to how to effectively respond to what continue to be tremendous challenges. Five years on from the GFC, investors are now enduring zero interest rate policies (ZIRP) and massive quantities of quantitative easing (QE) from most of the main central banks in an environment which has come to be known as financial repression. The question remains – why?
Whilst the capitalization of banks and other financial institutions has strengthened, most sovereigns have seen their overall levels of indebtedness stubbornly rise, in the midst of weaker economic growth. The result is that, on a net basis, we owe as much now as we did when the GFC struck. No deleveraging, or paying back of debt has occurred so far. Or has it? Investors beware, for this is where the alchemy of Financial Repression is so unobtrusively powerful. For these policies at work are, by design, keeping interest rates below the cost of living, (otherwise called inflation), thereby forcing savers and investors to either accept an apparent loss of purchasing power over a year or so, or to take higher and more uncomfortable levels of risk. As investors, how should we respond?
We are all being forced through financial repression to take risk, and allocating savings to equities is part of the solution.
Equities offer access to the underlying profits of corporates, engaged in often vibrant and expanding businesses around the world, who are generally able to avoid being caught up in national political troubles. Companies have also become highly agile and adept at growing new market share in other markets and benefiting from higher rates of growth in emerging markets or the recovering US market. Taking Europe as a whole for example, we find that over 50% of corporate earnings¹ originate outside Europe. Thus the hardship of austerity and restructuring in parts of Europe, and the tender shoots of recovery in some countries, may not have a strong impact on the growth or earnings potential of European companies primarily exposed to the emerging economies or the US economy.
The companies behind equities are living dynamic businesses, for the most part, which are motivated to invest, grow and deliver returns to their owners through capital appreciation, and, for many companies also through dividend income. Capital appreciation has, obviously, become the tricky part for many savers, with high levels of volatility in the equity markets affecting short-term returns. But long-term historical analysis shows that equities have been able to produce positive real returns, i.e. adjusted for the effects of inflation, over long-term periods of 20 years or more. Against this must of course be set the increased risk of investing in equities compared to lower risk asssets such as cash. We strongly believe that investors need to look beyond shorter-term market volatility and acknowledge the fact that an investment strategy of holding equities in the long-term not only protects purchasing power but also has the ability to achieve inflationbeating returns.
AllianzGI research has shown that dividends are particularly important during periods of Financial Repression because, with ZIRP at work in financial assets, overall returns tend to be lower so that the total equity return is boosted by the dividend and the dividend growth, which can have the opposite, but obviously positive, compounding effect that inflation has, in the negative sense.
Equity volatility will continue to plague the nerves of savers as equity markets can be affected by political or regulatory policies and whims, but longer-term investors may use times of market weakness to add to their equity allocations rather than to sell out. Financial Repression policies are not only set to last a long time but they work through creating inflation and promoting economic growth. Equity investing may be a solution to providing higher return potential to beat inflation and also offers investors the potential to benefit from an economic recovery, as companies are able to expand and grow their business and profits.
Although we may all be in this environment for many years to come, we surely must try and take a longer-term view in the interest of achieving the best investment returns and we also must remain optimistic. There is an old adage, "it is always darkest before the dawn" but as we have seen in 2013, Financial Repression is already eroding the returns from many bond portfolios and diminishing their purchasing power, whilst equities have not only blossomed but have added to the future purchasing power of their investors significantly. As we look ahead to a new year in 2014, we urge you to be bold, take smart risk and to reconsider your approach to investing in equities in the hunt for long-term attractive, inflation-beating returns.