Investing for abnormal times
The US stock market is close to all-time highs. Interest rate cuts and the demand for yield have generated strong returns in bonds.
Greek bonds recently doubled in "value" from around 13 per cent of face value to the high 20s, although they have fallen back a little.
Even so, investors should not think happy days have returned. As smart ones know, returns are about taking a long position and using a little bit of leverage. A rising tide, as they say, lifts all boats. But that may be all in the past. There has been a marked shift in the investment climate. Investors must reshape their tactics for abnormal times.
The world is moving to a slower growth path, affecting corporate earnings and equity values.
Recent strong corporate earnings were driven by cost cutting, low interest rates and government stimuli. Slow growth will constrain already indifferent revenue levels. Without underlying demand for products, corporate profit margins and earnings will be under pressure.
Asian companies' earnings will be affected by sluggish growth in developed markets and the slowdown in China.
The Viagra of investment - leverage - which drove high returns before 2007, is less available today as the global economy cuts debt. Bill Gross - the head of Pimco, the world's biggest bond fund manager - argues that equities have returned 6.6 per cent per annum in real terms since 1912, above real economic growth of 3.5 per cent. The higher return has, in part, been driven by leverage, which is less likely to influence future equity returns.
"Official" interest rates are low, but credit margins are high, and with inflation low, the real cost remains high. The supply of credit is likely to fall as European and US banks accept lower profits. Asian banks are expanding but cannot fully fill the gap.
Bank credit is now on more restrictive terms (lower loan amount as a percentage of asset value) and tighter controls for all but the best and largest clients. Risk-averse companies and individuals are also more cautious about borrowing, after recent near-death experiences. Central banks and policymakers are trying to create inflation using unconventional fiscal policies, quantitative easing and inflation targets. Inflation cuts debt by eroding the real value of obligations, but the strategy may not work.
While central banks provide ample liquidity, the effects on credit creation, income, economic activity and inflation are complex and unstable. Money's velocity, or rate of circulation, has slowed. Banks are not using the reserves created and money provided to increase lending, reflecting a lack of demand for credit from stretched households and businesses. The reduction in velocity offsets the effect of increased money flows and limits the pressure on prices.
Uncertainty about inflation levels complicates things. If policymakers restore growth with modest inflation, equities may prove the best investment. If the policies result in high or hyper-inflation (such as that experienced in Germany after the first world war or in Zimbabwe), then real commodities and precious metals such as gold may be the best investment. If the policies prove ineffective, then stagnation may result. In that case, bonds or other fixed-income instruments would work best.
Recently, equities, commodities, bonds and gold have rallied simultaneously, reflecting this confusion. For Asian investors who typically have some foreign exchange exposure, loose monetary policies affect investment value through the effects on the currency.
The US Federal Reserve policies are designed to devalue the dollar to cut the value of outstanding debt in that currency and improve export competitiveness. With all developed countries competing to weaken their currencies, the impact of foreign exchange fluctuations on investments - directly or indirectly through their effect on company earnings - is unpredictable.
Investment outcomes are now heavily influenced by government and central bank policies. Major central banks now dominate markets. Their collective balance sheets have increased from around US$6 trillion before the crisis to more than US$18 trillion, an unprecedented 30 per cent of global gross domestic product.
Based on Japan's experience, further rounds of central bank buying of risky assets can be expected. The range of assets bought may expand to include equities and corporate bonds.
The rally in the euro and European bonds and stocks after the European Central Bank announced it would purchase unlimited quantities of peripheral country debt showed the risk of misreading policy. As Gross repeated during the crisis, Pimco buys whatever the central banks are buying.
But predicting policy is difficult. Increasingly desperate policymakers and governments facing electoral pressures are motivated by political and social consideration rather than economic or financial factors.
Governments have resorted to "financial repression". They are implementing a range of policies to channel funds to official institutions to liquidate debt.
These include explicit or implicit control of interest rates, which are negative after adjustment for inflation. This helps governments decrease debt servicing costs and cuts the real value of its debt.
There will be increased interference in financial markets. Prohibitions on short selling, bond purchases and currency intervention are examples.
Successful investment requires recognising and minimising the effects of financial repression. To preserve capital and the purchasing power of their money in these abnormal times, investors will need to understand financial flux and negotiate its cross currents.
Satyajit Das is a former banker and author of Extreme Money: Masters of the Universe and the Cult of Risk