Much stock market analysis takes it for granted that there is a clear relationship between economic growth and the return on equity. That is a questionable assumption at the best of times. In the world of Covid-19 it is pure nonsense. The market recovery since the ultra high speed bear market in March owes nothing to rational assessments of the health of the corporate sector and everything to policy.
The turn in the market reflected investors' realisation that governments around the world would throw everything fiscally conceivable at the pandemic without troubling themselves with worries about debt sustainability. At the same time central banks rushed in, most notably the Federal Reserve, which loosened policy and rapidly attacked an acute liquidity shortage in the corporate bond market, thereby easing financial conditions. Balance sheet expansion has since been the order of the day.
These were undoubtedly the right things to do — though getting things right when the debt fuelled recovery is advanced will be a much tougher proposition. And there are snags, not least for pension funds. Against a demographically challenging background they are obliged to increase their exposure to bonds that yield little or no income and offer no reward for taking on interest rate risk. As has been widely remarked, bonds no longer provide diversification in a conventional equity-bond portfolio.
It remains possible in the deflationary climate induced by the pandemic that bond investors will make capital gains if interest rates fall further. Yet that will never compensate for the size of the potential losses if interest rates rise by anything more than a whisker. So-called safe assets are no longer very safe. And those capital gains would come at the cost of liabilities that soar because they have to be discounted at a lower rate.
Meantime, paying pensions out of securities that yield no income is going to be expensive, especially for sponsoring companies in sectors hard hit by the virus. Those securities will continue to offer little income because governments and central banks will want to keep interest rates low to secure lower borrowing costs on the soaring debt.
On the equity side of the equation, returns will suffer in the longer run because of the wider consequences of the central banks' actions. These ensure that the corporate sector's cost of capital is kept artificially low with the result that companies over-invest and capital productivity — the ratio of output of goods and services to the input of physical capital — is weakened. This is a drag on both economic growth and equity returns.
All this suggests a low-return world. Eric Knight of fund manager Knight Vinke argues that reinvestment risk may turn out to be the single most destructive risk now facing long-term investors — the risk that investments providing a good return today cannot be replaced by equally attractive investments tomorrow when the existing ones reach maturity.
He points out that a reduction in average returns from 8 per cent to 6.5 per cent will cut the value of a pension fund's portfolio, reducing it by 35 per cent in 30 years and by 50 per cent in 50.
Whether most pension funds are positioned for a lower return world is moot. For example, research by the Pew Charitable Trusts shows that the 73 largest state-sponsored pension funds in the US reduced their average assumed return from 8 per cent in 2007 before the financial crisis to about 7.5 per cent in 2016 and to 7.3 per cent in 2017. That substantially lags the decline in bond market yields.
How should investors respond to this environment? Knight argues that the way to reduce reinvestment risk is to invest in projects with very long lives. Having earned a reputation for successful shareholder activism, he now adopts a lower profile, seeking to create value through forensic analysis of complex public companies and engaging with a broad range of stakeholders to crystallise the value.
Often this means restructuring conglomerates in which the capital productivity of subsidiaries has fallen because of over-investment. He is also attracted by real assets such as residential property, where work by economists at the San Francisco Fed has shown that returns over the past 150 years have matched those on equities.
Knight Vinke's change of direction has produced impressive results. It claims a five-year annualised return to 2019 of 26.2 per cent net of fees. Sustaining that breathtaking pace will be quite a challenge.
Written by: John Plender
© Financial Times