While interest rates may be back to their pre-Lehman highs, the investment environment is not back to business as usual.
- Government bond yields remain low compared to longer-term averages
- Equity risk premia for developed market equities are low, but emerging markets are far higher than their long-term average
- High debt leaves developed market economies looking vulnerable
It is 15 years since the Lehman bankruptcy, and UK interest rates have come full circle: from 5% to 0% to 5% again. The extraordinary monetary policy that sent technology shares, private equity and government bonds soaring appears to be over and looks unlikely to return in the near-term. Will this mean a wholesale reversal of the investment ‘rules’ of the past 15 years?
Certainly, government bond yields have risen and fixed income appears to have returned to a more normal environment. That said, according to the findings of Robeco’s research ‘Expected Returns 2024-2028: ‘Triple Power Play’, they remain low compared to longer-term averages. It points out that the long-term average for German government bond yields is closer to 4%, rather than the current level of 2.5%.
Part of the problem in a wholesale reversal for government bond yields is the vast debt accumulated by global governments during the financial crisis and the pandemic. This debt is acting as a dead weight on many Western economies and stymying the growth that might ultimately see it reduce. It is a recipe for stagflation.
In stock markets, there have been plenty of optimistic value managers saying that the new environment may favour a different type of stock – one with reliable cash flows and dividends today rather than the promise of high growth tomorrow. The reality has been slightly different: some value areas have performed well, but investors have not rediscovered any enduring enthusiasm for the ‘old economy’ end of value investment. Neither have they lost their enthusiasm for the technology sector, with artificial intelligence powering it higher.
Robeco’s analysis of the implied equity risk premium in markets, however, suggests that there may be an imminent reversal in the performance of emerging markets over developed markets. The expected return on equities relative to bonds for developed markets has decreased significantly and is now below its long-term average, though there is a notable gap between the US and Europe. For emerging markets, the long-run equity risk premium is well above its long-term averages. With lower debt, improving productivity and cheaper valuations, emerging markets have some notable advantages in the current climate.
Another key difference in the pre-Lehman world versus the post-Lehman world is that developed market governments have no firepower left. While they had the capacity to cope with shocks prior to Lehman, that capacity has been eroded. That leaves them vulnerable to whatever shocks come next.
Then there are a range of new factors with which markets need to contend. Environmental adjustments need to be made, AI could be friend or foe, geopolitical tensions are reshaping the world order. While the investment rules of the past 15 years no longer apply, there are a whole new set that investors have to learn.
