Why li­a­bil­i­ties hold the key when gaug­ing fu­ture in­vest­ment re­turns

The Sunday Telegraph - Money & Business - - Business - Keith Skeoch is the co-chief ex­ec­u­tive of Stan­dard Life Aberdeen KEITH SKEOCH

We lived through his­tory on Thurs­day. The Bank of Eng­land raised in­ter­est rates for the first time in 10 years. But in­ter­est rates will stay low for a lot longer yet and this should en­cour­age those with a long-term view.

This week’s move was sym­bol­i­cally im­por­tant – a re­minder that in­ter­est rates can move up as well as down. But of course it was no sur­prise. We were firmly steered to­wards a quar­ter-point rise by the Gov­er­nor of the Bank. It sim­ply re­verses the cut made straight af­ter the EU ref­er­en­dum, and UK in­ter­est rates still re­main ex­cep­tion­ally low. In fact, the Bank of Eng­land is far from be­ing alone in tight­en­ing mon­e­tary pol­icy. At least 12 coun­tries have done so this year, led by the US.

The re­ac­tion to the de­ci­sion and, in­deed, all these moves has been fairly be­nign. A big sell-off of govern­ment bonds has failed to ma­te­ri­alise de­spite higher short-term in­ter­est rates and cen­tral banks in­di­cat­ing they will un­wind bloated bal­ance sheets.

Even height­ened un­cer­tainty – whether that be Brexit or North Korean mis­siles – has failed to shake mar­kets’ nerve. This year has been a strong one for eq­uity mar­kets, which in many cases have hit record lev­els. The abil­ity of mar­kets to re­main un­per­turbed in the face of so much change is caus­ing some to worry. They see signs of bub­bles form­ing.

Part of the con­cern for both in­vestors and pol­i­cy­mak­ers must be that, as the painful mem­o­ries of the fi­nan­cial crash fade, so does the height­ened level of risk aver­sion that has dom­i­nated the last decade. Many cen­tral bankers have warned about the risks of too much debt build­ing up, driven by ex­cep­tion­ally easy mon­e­tary pol­icy. His­tory, how­ever, sel­dom re­peats, and the land­scape that mar­kets op­er­ate in now is very dif­fer­ent to that of even a decade ago.

Of course, the level of some eq­uity mar­kets rel­a­tive to their own his­tory should give pause for thought. But their re­turns look pretty at­trac­tive when you com­pare them to in­ter­est rates. It is this dif­fer­en­tial be­tween long-term in­ter­est rates and the re­turns avail­able in fi­nan­cial mar­kets that we should pay most at­ten­tion to.

One of the im­por­tant but largely un­her­alded lessons of the fi­nan­cial cri­sis was not just to look at as­set prices in iso­la­tion but to pay par­tic­u­lar at­ten­tion to the li­a­bil­i­ties they were match­ing or back­ing. Li­a­bil­i­ties are an equally vi­tal part of fig­ur­ing out what will hap­pen to in­vest­ment re­turns.

The com­bi­na­tion of reg­u­la­tion and mas­sive falls in gilt yields has had the ef­fect of in­flat­ing the li­a­bil­i­ties of large in­sti­tu­tional in­vestors like pen­sion funds and in­sur­ance com­pa­nies. A decade of ul­tra-low in­ter­est rates has kept the price of many of the so-called safe as­sets that pen­sion and in­sur­ance com­pa­nies hold low. This has made it in­creas­ingly hard for these in­vestors to achieve their re­quired re­turns and forced them into per­ceived riskier as­sets. Mov­ing into other as­sets has in turn re­duced the re­turns avail­able from them and the prob­lem of meet­ing li­a­bil­i­ties has only grown.

In­deed, if there is a bub­ble in fi­nan­cial mar­kets it is ar­guably in li­a­bil­i­ties. Whether the high level of li­a­bil­i­ties con­cerns you or not de­pends on your view of what hap­pens to reg­u­la­tion and in­ter­est rates. If reg­u­la­tion re­mains as it is and in­ter­est rates stay low, then the con­di­tions ex­ist for li­a­bil­i­ties to stay at this very el­e­vated level for some time. There is lit­tle or no sign of reg­u­la­tion chang­ing soon. Sim­i­larly, in­ter­est rates may be ris­ing but they will re­main very low by his­tor­i­cal stan­dards. Rates will also stay low as long as in­fla­tion does, and the prospects of in­fla­tion in­creas­ing sig­nif­i­cantly re­main slim.

Fi­nan­cial his­tory demon­strates how in­fla­tion can re­main phe­nom­e­nally well an­chored for long pe­ri­ods. It is the struc­tural im­pact of this across the in­vest­ment land­scape that is go­ing to de­fine re­turns in the years to come. Val­u­a­tions might look scary in the short term but, over the long term, there is room to grow yet.

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