There are so many disturbing aspects to the financial crisis that it is difficult to focus. In the finance industry itself, it’s as if whole organisations are paralysed in a hopeless pessimism.
Notwithstanding the self-fulfilling nature of this gloom, as the rest of the world starts to slide down the same slope, there are still pockets of light which deserve wider recognition. The first is that many markets have probably overshot fair value on the downside by a wide margin.
The credit markets, for instance, have spreads near 100-year records, according to an interesting study by Deutsche Bank strategists in London. The study – ‘Fundamental Credit Special: 100 Years of Corporate Bond Returns Revisited’ – is a revision of a report first published in 2005, around the time of the peak of the US housing bubble. Believers in mean reversion (and shouldn’t that be everyone?) would have seen that there were tough times ahead for investors.
As one long/short manager said last month as the Australian ban on nonfinancials shorting was just lifted, “If you could have shorted US sub-prime mortgages, the world wouldn’t be in this mess.” The latest Deutsche Bank study says: “Three years later, and in the midst of a once-in-a-lifetime credit crisis, much has subsequently changed in valuations relative to very long-run averages.” If all asset classes revert to the mean over the next 10 years, the worst place to be will be in US treasuries, where real (after inflation) returns have been positive for four decades after four decades of negative returns between 1940 and 1980.
Following the sell-off of the last two months, US treasuries are now the best performing asset class over the past 25 years, beating equities, credit, property and oil. “This really is an amazing statistic in what is widely seen to have been a golden age for investing in risk assets,” the Deutsche report says. While it continued in Australia for a few more years, the golden age for equities ended in the US in 1999. This decade (with slightly less than eight years gone) is actually the worst for US equities real returns in 110 years, with minus 5.1 per cent till the end of October.
The 1930s were actually positive, with a 2.18 per cent real return. But the 25 years to 1999 were so good, that the US share market has to fall further for it to reach its long-term mean. The study concludes: “…the extreme stress in the cash credit markets, with spreads at around all-time (100 year) wides, has left the asset class with the most to gain from mean reversion. Double-digit annual returns are a realistic possibility over the medium term, even as defaults pick up…” The second pocket of light is China. Admittedly the light is not as bright as it seemed a few months ago, but it is still shining.