2017 was uneventful. Really? What else could we deduce, though, from a year (the tenth since the global banking crisis first started to unfold) in which exceptionally low bond yields stayed low and equities continued to rise, by slightly more than their long-term trend and with exceptionally low volatility? As for the big political currents like Brexit, a hung parliament and Trump, there is no sign of them in the market data. If there were any economic or valuation anomalies at the start of the year, they did not disappear during the year, let alone cause any market upsets.
From our perspective, the only significant anomaly was in those markets directly affected by unconventional monetary polices since the crisis: deposit rates and bond yields. Quantitative Easing (QE) continued to distort bond pricing, even though several economies saw modest increases in short-term interest rates. A return to more normal bond pricing, which was widely feared at the start of the year, did not happen.
Undisturbed by competition from higher bond yields, equities were free to build on their gains since the bull market began in March 2009. Have they gone too far? This depends critically on whether equities are valued on the basis of conventional inputs such as earnings and dividends or in terms of their long-term return trends. Fundamental valuation measures have left major markets, particularly but not only the US market, looking increasingly stretched. The popular narrative has this as a by-product itself of QE, although it is striking that there is more talk of an equity bubble than a bond bubble.
Relative to long-term return trends, equities are not at all in bubble territory, even after another good year. The US market ended 2017 on our measure about 13% above its own long-term trend rate of 6.2% pa. Extreme peaks (in the 1920s, 1960s and 1990s) were as much as 60-70% above trend. Europe ex UK just edged above trend in the final quarter. But the UK, Australia and Emerging Markets ended between 4 and 8% below their trend returns. Japan, though it participated fully in the good year for equities globally, was still 24% below its lower (4.8% pa) trend by year end.
Though deviations from trend are important for our projections of outcomes for long horizons, they tell us nothing about the short term. Several equity bear markets have started from ‘normal’ absolute valuations, having been triggered (typically) by events in bond markets. As crisis-era monetary policy normalises, this could obviously happen again.
How are our clients protected against this? Not by making calls about inflation, monetary policy or market timing. But they are protected by a consistent risk-management framework. Its key characteristic is using hedging assets (which in contrast to conventional portfolios do not include any nominal bonds) to control the range of possible outcomes at the time horizons at which access to capital is expected to be required. As a consequence, needs for capital arising in the period in which this huge monetary policy uncertainty mainly falls, up to about 5 or 10 years (depending on risk tolerance), are already hedged.
Normalisation may well lead to much higher equity volatility than recently but that is not a threat to planned goal outcomes. And if price movements diverge more between markets, that will present us with more return-seeking rebalancing opportunities. These have been all too few in recent years – though even without them our equity performance has been better than our benchmarks.