The internet certainly has its faults, but one can’t but admire how it has democratised information. It is now possible to get access to a multitude of private-sector reports that would only have been available to investment professionals a mere 10 years ago.
One example, with a high degree of quality, is the Credit Suisse Global Investment Returns Yearbook. You can get a pdf of the 2013 report here. Within its pages is a wealth of information on cash, bond and equity returns. Critically, the report chronicles a recent revolution in the prospects for investments. Moreover, the ‘new normal’ savers face gives off some telling signals with respect to future economic growth and, unexpectedly, provides some good news for the economics of sustainability projects.
The three authors behind the report—all from London Business School—provide a short introduction that doesn’t pull any punches in its message to the investment community:
To assume that savers can expect that the investment conditions of the 1990s will return is delusional. Many investors seem to be in denial, hoping markets will soon revert to “normal”.
The report covers cash, bonds and stocks, and all three have seen a collapse in expected returns. Let’s take a closer look at bonds, since they dominate pension-related savings in most countries. You can plainly to see that nominal yields have slumped (click for larger image):
But once we take inflation into account, things are far worse. In the chart below (taken from the full report), the authors have used inflation-protected bonds starting from the year 2000 (or equivalent where such bonds are not issued by a particular country) to see what kind of real returns investors are prepared to accept (click for larger image).
This kind of chart always shocks me. With traditional bonds, investors are on occasion ambushed by inflation and accordingly have to accept negative real yields, yet, in the case of inflation-protected bonds, investors are locking in negative real yields up front!
I have blogged on this issue before in a couple of different contexts (here and here), but it is worth stressing, to those without an economics or financial background, the extraordinary nature of this phenomenon. In standard text books, an interest rate is a payment to defer consumption. The basic assumption within economics is that, other things being equal, an individual will prefer to consume something now rather than consume it in the future. But, nowadays, when you buy these inflation-protected bonds, you are saying that you will give up the chance to consume something now in order to keep the opportunity to consume something in the future—even if it will be less of that particular thing.
Why should this be? The authors flag two possible factors behind the collapse in real yields: a changed regulatory environment and demographics. Further, they suggest that since neither factor will change anytime soon, don’t think the world of temporary negative yields is an anomaly—so get used to it (although they backslide on this assertion for the very long term right at the end of the report, presumably thinking it is just too awful to be true).
Personally, I don’t think this tells us the whole story. If technology-led productivity was barrelling along at its post-war average pace, then that would be sufficient to overcome a greying society and a tougher financial regulatory environment. Perhaps, real yields should be lower than in the past, but they shouldn’t be negative.
To me, if someone is prepared to buy a 20-year inflation-protected bond that provides a negative yield, then they are saying that alternative investments in something real, for example plant and equipment, are likely to perform even more poorly than loss-making bonds when risk-adjusted.
In what kind of world could that be true? I think the answer has to be a post-growth world. And where would the drag on growth be coming from? Well this blog has three candidates in mind. Maybe, climate change will be gnawing at growth quite aggressively by the year 2033—and so perhaps could resource constraints. Alternatively, Robert Gordon’s faltering innovation could do the job alone or in conjunction with the other two—we just don’t know.
What we do know, however, when looking at the real returns on cash or bonds is that something pretty revolutionary is going on. It’s been five years since the credit crisis erupted, and things really don’t look like they are reverting to past return patterns. With each passing year, the cliched ‘new normal’ looks, well, just ‘normal’.
So where is the silver lining? For me, the silver lining is that sustainable investments have a far lower hurdle rate to overcome. By definition, many sustainable investments have long time horizons (that is why they are sustainable) and long pay backs. This has traditionally been their Achilles’ heel when fund raising. But far from a weakness, this could now be viewed as a strength: many sustainable investments can do something that traditional cash, bond or equity investments are finding it increasingly hard to do; that is, generate a reliable return far into the future.
Take an example at the individual level. A 50-year old currently has a pretty bleak set of options when saving for his or her retirement. Even if earned income is put into tax-efficient wrappers, a well-balanced portfolio may struggle to get a positive real (which means inflation-adjusted) return. By contrast, diverting some of the retirement savings into home heat-efficiency investments could lock in cost reductions decades into the future—including into retirement.
Such an alternative retirement-preparation strategy would also reduce risk in three dramatic ways. First, it would protect the saver from a government attack on their pension pot through negative changes to the tax system. Second, it would provide some immunity from inflation, keeping in mind that the government may be forced into a stealth inflation tax to deal with its debts. Third, energy efficiency investments would reduce exposure to future fuel prices spikes arising from resource depletion or adverse geopolitical developments.
Nonetheless, is it possible that we are just in a prolonged downturn, which, by definition, implies that there will one day be an upturn. Indeed, the authors of the report seem to be believe that we are in a tunnel, albeit a very long one, from which we will eventually emerge:
For how long can we expect returns to be low? It could take another 6–8 years for short-term real interest rates to turn positive, and markets are not expecting a return to the high levels experienced since 1980. Instead, markets suggest a drift in the direction of the long-run average of 0.9 percent for the US and UK. For how long are low returns bearable? For investors, we fear that the answer is “as long as it takes”. While a low-return world imposes stresses on investors and savers, it provides relief for borrowers. The danger here is that if this continues too long, it creates businesses kept alive by low interest rates and a reluctance to write off bad loans. This can suppress creative destruction and rebuilding, and can prolong the downturn.
I am not so sure. Just as with climate, with respect to which we are moving from the holocene into the anthropene with no chance of return (at least in any human life time), so could the investment environment be experiencing a similar transformation. But you don’t have to put all your eggs in one basket in such a debate. Sustainable investments, at the very least, can just be viewed as a prudent hedge.