Up until last year investors had experienced two decades of low inflation, falling interest
rates and easy money, but since the start of this year the winds of change have been
blowing quite hard.
Inflation is rising, having hit 8.6 per cent last week - the highest level since December
1981.
Monetary policy is tightening, and we're seeing significant geopolitical risks, the likes
of which we have not seen in a long time.
According to a recent survey in the Financial Times, nearly 70 per cent of leading economists
expect the US economy to fall into recession next year.
The US central bank has begun what it looks like will be one of the fastest tightening
cycles in decades.
The FOMC raised interest rates from near zero in March to a target range of 1.50-1.75 per
cent earlier this week, stating that they “anticipate that ongoing increases in the
target range will be appropriate”.
The Fed chair admitted that the path to bringing down inflation without causing significant
economic damage was “not getting easier”.
The Fed has committed to moving “expeditiously” to a neutral setting — one that neither
stimulates nor slows down growth — although Powell recently conceded that this threshold
was “not something that we can identify with any precision”.
Rather, he vowed to keep pressing ahead until there was “clear and convincing” evidence
that inflation was moderating.
So, is there anything that we can learn by looking at the history of asset returns that
might guide us in the markets that we see today?
Well, the global investment yearbook from Dimson, Marsh and Staunton, three professors
from London Business School is the most comprehensive database of global investment returns available,
it contains 122 years of global market returns collected from a total of 90 developed and
emerging markets and gives us the best historical vantage point to try and understand what is
happening in markets today.
Over the 122-year period that they have studied, there have been numerous periods of rising
inflation, rising interest rates and we've seen some very extreme geopolitical unrest
which includes the two world wars as an example.
So, let’s first discuss what historical investment returns over the entire period
have looked like and then focus in on a major concern for investors today which is inflation
and of course the cure for inflation which is the interest rate hikes that we are seeing
right now.
OK, so over the entire 122-year period, we have seen positive real returns (meaning inflation
adjusted returns) in equity markets, with the American stock market having the highest
inflation adjusted returns and Austria showing the worst returns.
Even though Austria did have the worst returns, they still beat inflation.
The fact that the US has had the highest returns over that period might mean that it is unwise
to extrapolate future returns going forward just using US data, which is quite frequently
done, simply because US stock price data is most easily available to researchers.
Overall, it might make more sense to focus on market cap weighted global returns when
making projections.
So, based on this long series of data, equities (or stocks) beat inflation everywhere in the
world in the long run, which is good to know.
Now, when we look at Bond returns, these were not positive everywhere in the world when
adjusted for inflation.
There were five countries where real bond returns - meaning inflation adjusted bond
returns - were negative over the 122-year period.
You can see from the data that equities not only beat inflation, but they also beat bonds
everywhere in the world.
Finally, when we look at bill returns (bills being short term bonds – or the return you
would get on your cash), you can see that equities provided higher returns than bonds
and that (other than in Portugal), bonds outperformed bills.
So, in the long run overall, the law of risk and return seems to hold, where the riskiest
securities – stock market investments, outperformed intermediate risk assets like bonds, which
generally outperformed the safest assets – bills – or cash.
Now, the US stock market returned 6.7% above inflation on an annualized basis over the
122 year period, The world index excluding the United States returned a more modest 4.5%
over the same period, and the average stock market returned 5.3 percent above inflation
annually over the last 122 years.
So, that might be the most reasonable return expectation for the average investor going
forward.
The 5.3% inflation adjusted return on global equities beats the 0.7% annualized real return
on bills and the 2.1% real return on bonds.
The equity risk premium is the amount by which equities beat the risk-free rate, and so,
over the 122-year period that comes out as 4.6 percent.
So, the additional return that investors have received for taking stock market risk in the
long run has come out as 4.6% per year of excess returns over cash.
One other observation we can make when looking at this data is that when we look at the countries
with the worst performance over the 122-year period, they appear to have been the countries
that were most negatively impacted by the two world wars.
Now when we look at a chart of the evolution of global equity markets over time, one of
the most noticeable things is the growth of the US stock market relative to the rest of
the world over that period, and then, to a lesser extent Japan’s growth and decline
over the same time frame.
We should note that markets have of course changed quite a lot over time, and they always
will change going forward.
Stock markets in 1900 were very different in the way they worked, and in the types of
companies listed to markets today.
This is also not a complete market history either.
In 1900 when the database began, the Amsterdam exchange was already almost 300 years old;
the London Stock Exchange was more than 200 years old; and five other markets, including
the New York Stock Exchange, had been around for 100 years or more at that point.
Looking at the data we can see that investors in different countries had quite different
returns over time too.
Many countries experienced market closures during wartime.
In Russia and China markets were closed when the communists took control with no intention
of reopening and assets were expropriated by the governments in question.
The varying outcomes highlight the wisdom of international diversification for investors.
So, what does this mean for forward looking investment returns?
Well, we can think of returns as being made up of the real interest rate plus a premium
for taking risk, and that calculation applies to any asset class you might want to consider
investing in.
So, the first thing we need to look at in that case, is where real interest rates are,
and what they have been doing.
This chart from the yearbook shows that real interest rates over the last 22 years have
fallen from just below 4% to a global average of minus 1.5% at the end of 2022.
This decline in real interest rates has been very good for asset returns over that period,
but unfortunately as real interest rates rise, it does not help asset values, it harms them.
If we analyze investment performance starting in periods of low real interest rates compared
to high real interest rates, with a five-year holding period, we can see that bond returns
are low when initial real interest rates are low, and that bond returns are high when initial
real interest rates are high.
That is only so surprising...
You can see a very similar picture for equities too.
So, the returns of both asset classes are very much grounded in what the real interest
rate was at the start of the investment period.
If you start with a low real interest rate you can expect low subsequent returns and
if you start with a high real interest rate you can expect high subsequent returns.
OK, so next up let’s discuss inflation.
In the United States, annualized inflation rate since 1900 was 2.9% per year, compared
to 3.6% in the UK over the same period, but this seemingly small difference, thanks to
the power of compounding, means that, while US consumer prices rose by a factor of 33,
UK consumer prices rose 73-fold over that same 122-year period.
Prices didn’t however rise in a steady manner, and all around the world, all countries experienced
deflation at some stage in the 1920s and early 1930s.
In the United States, consumer prices fell by almost a third in the years after 1920
and didn’t regain their 1920 level until 1947 – so 27 years later.
So, what about in more recent times?
Well, after experiencing the highest inflation of any country in the first half of the 20th
century, Germany had the second-lowest inflation rate from 1950 onward (with Switzerland having
the absolute lowest).
Several countries, including the UK, went from having comparatively low inflation to
becoming relatively high inflation countries in the second half of the 20th century.
While US inflation was higher from 1950 onwards than it had been before, America's inflation
rate was below the average of other countries in both periods.
In many countries, inflation peaked in the 1970s and was gradually brought under control
thereafter.
Five countries in the database experienced extremely high annualized rates of inflation:
70% in Argentina, 64% in Brazil, 28% in Chile, 19% in Mexico, and 16% in Russia.
Argentina was the most extreme and, over a 22-year period from 1970 to 1991, inflation
never fell below 20%.
It exceeded 100% in 14 years and peaked at 5,000% in 1989.
Over the last 15 years, it has been below 20% just once.
Brazil came a close second, also experiencing a 22- year period when annual inflation never
fell below 20% and six calendar years during which inflation was close to or above 1000%.
More recently, Brazilian inflation has been largely under control.
Over the last twenty-five years, global inflation has been very low by historical standards.
On average, in each year from 2008 through to 2020, over half of the countries covered
had an inflation rate of 2% or less.
In 2020, only one country had an inflation rate above 2% and the average inflation rate
was just 0.42%, which was the lowest level since 1934.
Everything then changed in 2021, when inflation rose substantially in most of the developed
world.
It went from 1.4% to 7% in the United States that year (the highest annual figure for 40
years).
In the UK it went from 0.6% to 5.4% (the highest annual figure for 30 years), and from −0.3%
to 5.3% in Germany (the highest for 40 years).
In early 2022, inflation has continued to accelerate hitting 8.6 per cent in the United
States last week.
Looking globally, the average inflation rate across the 21 countries went from 0.42% in
2020 to 4.4% in 2021 - a tenfold increase in annualized inflation over a one year period,
and as we know inflation has continued upwards in the first half of 2022.
This resurgence of inflation – particularly in 2021 was triggered by global economic stimulus,
high consumer demand as economies recovered, severe supply chain disruptions, which we
have all heard about at this point, and a poorly anticipated global energy crisis, which
had started before the war in Ukraine and has only intensified since.
Additionally, we have been seeing food shortages due to weather issues, transportation issues
and the Russian invasion of Ukraine.
This recent strong uptick in inflation in most developed economies has raised the obvious
question about its likely impact on asset returns.
So let’s look at how investors have fared, when inflation has been low versus when inflation
has been high.
Looking at the data you can see that bonds have their worst performance when inflation
is high and deliver their best performance in deflationary periods.
They work really well as a hedge against deflation.
But that is not the problem right now…
When we look at equity returns, you can see that equities perform worse when inflation
is high.
And give negative returns when inflation is extremely high.
So, equities are not an inflation hedge – or at least not helpful in periods of very high
inflation, but in the long run they have been an excellent inflation beater.
This is not because they are an inflation hedge though, it’s because of the equity
risk premium.
OK, next up, let’s look at interest rate hikes and their effects on investment returns.
If we look at US Federal reserve official interest rates from 1914 till present, we
can see that there are cycles of rate hikes and rate cuts.
Now you can't know when you are at the top or at the bottom, in terms of cycles, but,
if you followed a rule, which you could have followed in real time, where you either invest
upon the first interest rate hike and hold until the first interest rate cut, or you
take the opposite strategy, of investing upon the first interest rate cut and hold until
interest rates are next hiked we can then look at what your returns would have been
in those two scenarios.
When we look at the returns of these strategies for both the USA and the UK, we can see that
returns were much higher for investors who invested after the first rate cut rather than
after the first rate hike.
This was the case in equities and bonds for both countries.
You can see that inflation was higher after rate rises than rate cuts in both countries,
and that is just because it typically takes more than one rate rise to bring inflation
under control.
Now when we look at the same data, but as risk premiums after interest rate hikes and
interest rate cuts, you can see that investors are really well compensated for taking risk
in rate cutting cycles, with an equity risk premium of 9.3% for US investors, and an equity
risk premium of 8.1% for UK investors in rate cutting cycles.
Risk premiums are much more modest in hiking cycles, coming in at 2.7% in the United States
but worse yet, we discover that the entire UK Equity risk premium was earned during rate
cutting cycles.
Ok, so is this just down to risk?
Is it just that risk is higher during falling interest rate periods?
Well, when we look at volatility, we can see that risk is a little bit higher during cutting
cycles, but if we look at sharpe ratios, which is a reward for risk ratio, you can see that
sharpe ratios were much higher during cutting cycles, than in hiking cycles.
So, risk adjusted return is just higher for those who invest when interest rates are first
cut.
It is a better time to be taking investment risk.
Now, this is sobering stuff, especially in the current economic environment, which leads
to the question, should we be deeply pessimistic right now?
Well, the rate hikes that we are seeing have been signaled for quite a while, and we are
a bit into the hiking cycle in most parts of the world already.
Markets began their decline before the first rate cuts, and the frothiest areas of the
investment universe sold off the strongest.
There are lots of market sectors that did not run up much in the recent bull market,
and so they might be less affected in a risk off environment.
We should also note that these are long run averages that we are looking at, and they
conceal very big differences between the different hiking and easing cycles that have occurred
over time and around the world.
There are many interesting lessons we can glean from this data and being aware of how
these events generally affect markets might help you out as an investor in the long run.
You can see the long run outperformance of stocks over bonds and bonds over bills.
You can see what a reasonable inflation adjusted return expectation might be for varying levels
of risk.
You can see the benefits of compounding returns.
One take away is that investors might want to consider adjusting their stock/bond allocations
over time based on hiking and cutting cycles.
Historically once inflation has gotten above 5% it has never come back down without the
fed funds rate being raised above the CPI, but of course as I mentioned, each situation
is different to the next, and some of the causes of inflation that we are seeing right
now may be somewhat unwinding already.
We should note that a lot of the inflation that we are seeing right now is driven by
things like grain shortages, fuel shortages and computer chip shortages.
These relate to very specific world events and political decisions.
Pushing up interest rates can’t be expected to increase oil and gas production, or produce
more computer chips that are needed in modern cars.
There is a lot to be learned from paying attention to market history, especially when looking
at global returns as are covered in this research report.
I have put a link to the full report in the video description below.
Have a great week, and talk to you soon, bye.