The Swing Is Away From Equities

The world economy is in a downward spiral, which was unimaginable till a year ago, and the equities market just touched a historic low. So, what's in store for investors in the medium to long-term? ETIG's Pallavi Mulay and Krishna Kant spoke to ING Groep's chief economist Rob Cornell to get a long-term perspective on the global economic crisis and its implications for the investors. Incidentally, Mr Rob was one of the
first economists to forecast the US housingled slowdown back in the autumn of 2005

How do you reconcile to the fact that it was much easier to recommend equities at the top of the bull-run but not now, when they are quoting at a historic low?
    This is paradoxical, but the most important time to give investment advice (in equities) to investors is potentially right now. No one can say, for sure, that we are right now not at the bottom of the crisis and at the verge of a stock market rally. The current revival is a bear-market rally and has some legs, which will take to forward for a while. But, we have not seen the final trough, or the final capitulation, in the equity market, as yet. If we believe that the US is the driver of the global business cycle and the financial market, some of the leading indicators of corporate profits suggest that we will decline further. Our indicators are based on the GDP data that, we believe, work better than those based on other indicators.
But don't you think equity markets bottom out before corporate earnings..
    Yeah, that's true. But we still foresee corporate profits going down in the near term. However, having said that, I must admit that the bottom is not million miles away. It may not happen in the near quarter, but it will happen the next quarter or the quarter thereafter. And if that happens, it will coincide pretty soon with the recovery in the stock market.
Then will you suggest that investors should start accumulating stocks at the current level?
    It will very much depend on the profile of the investor. They have to look at their risk appetite. If you are a portfolio manager of a balance fund and if you underweight equities, you should start buying now. This is because you will anyway have to buy at some point and if you wait too long for the market to hit the bottom, you may be able to buy enough stocks at the right price on their way up. You would rather end-up drive the market up. So these guys would surely be thinking of buying right now. As for retail investors, timing is not so critical. Stock market is not going to rally 30% in the space of one week, though it may happen in a period of two weeks.
Don't you think a 30% rise in benchmark indices in two weeks is too much to expect?
    It's entirely possible. The figure may seem too big in percentage terms, but given the fall, it is a relatively small bounce, if you draw it on charts. So, I don't rule it out altogether. In some of the hammered sectors, such as financials, we are finally seeing some goods news. It seems that the banking system (in the US and Western Europe) is not going to be nationalised, and you can really see substantial gains there. So, it's very difficult to make a concrete call, but if you miss this, you will probably miss one of the biggest rallies in a life-time. If you are a fund manager, you will probably spend 10 years catching up. If you are a private investor and thinking of starting your retirement planning, this is probably the right time. I am not advocating that everybody should pile on, but taking a slightly less dismissive view of the equity market will be the right approach. One way is to start averaging out — making a small but regular investment that makes sure that you, at least, capture some of the bottom.
    Last one-and-a-half-year has seen volatile and dramatic twists-and-turns in the global financial markets. How do you expect these to affect the longterm choices of investors especially with regard to their preference for various asset classes?
    There is substantially a large long-term implication for investors in this turmoil. And I am afraid that most of them are bad in the sense that last 10 years, we had a faster economic growth with a strong credit growth, low volatility and low spreads. And
    this enabled all the asset classes to do well. And all of them, equities, bonds, etc., did well. And commodities did extremely well. Basically, everything flew. Next 10 years will see exactly opposite. We are not going back to a period of strong credit growth of the past. Going forward, credit growth and overall economic growth is likely to be much lower. This will create unpleasant trade-offs between returns on various asset classes, inflation and overall economic growth rate. Assets always love the combinations of low inflation and high economic growth, but that is not going to happen. For every given level of economic growth, we will have a much higher inflation than in the past. If you have deposited in fixed income instruments, you will do slightly better than your peers, who emphasise on other asset classes.
Even better than equities… Not really. Let us think in terms of equityrisk premium. Fixed-income instruments may not necessarily give better returns than equities. The above analysis doesn't necessarily means that bond yields will be superior or interest rates will be higher than that in the past. What I am saying is that for every given level of economic growth, the corresponding level of bond yield and interest rates would be much higher than that in the preceding 10 years. You may have the same levels of interest rates or bond yield, but then overall economic growth rate will be lower. And this translates into lower growth in corporate earnings, which will then feed into equity returns. So even though equities may do well, they will not be able to repeat there past successes.
But what about the difference or spreads on returns of various asset classes, e.g. between equities and bonds? Will it be narrower going forward?
    Yeah, I think you are right. The swing is away from the equity market, once we are out of this initial bounce whenever it happens. Going forward, the swings are much less favourable to equities and in that sense, the opportunity loss to the investors of fixed income instruments will be much less than that in the past. One of the things that we saw in last 10 years is that volatility, i.e. risk, got compressed by a wall of savings from Asia. This compressed everything and everyone could buy more of everything without worrying about the risk, as on historical basis, they didn't matter at all. Now, this strategy will work only if risk remains low. Are we going to get such an environment once again? That will require once again a wall of credit to compress volatility. No one thinks we are going to go back to such an environment once again.
In the US, many pension funds steadily increased their exposure in equities. Does this mean that they will now cut down on their equity investments, which will then have repercussions for the entire world?
    We are already seeing this in a number of pension funds in OECD countries including the UK and the US. In latter, we have quite a few of the pension funds systematically moving out of equity, some entirely and moving into fixed income. When they did this, the timing may not have been entirely right. But you have to think of risk adjusted return and not the overall return. So these are tricky decisions to make.
Do you support the ongoing argument in India that pension funds should be allowed to invest in equity market?
    There is no reasonable argument to have a proportion of your investment in equity markets. The question is what the right proportion is. Then you have to think about risk –return profile and whether you have adequate diversification. I will expect funds to have at least some exposure to equities.
In India, equities still doesn't account for more than 10% of the pension funds under management…
    That is very low for me. From a diversification point of view, equities should constitute anywhere between 40-60% of the funds depending on the risk profile of the investee. It could be less if you have two years left and much higher if you are 15-20 years away from retirement.
Last 10 years, almost all sectors and all kinds of firms did well on bourses. Can we expect the equity market to discriminate much more between various sectors and kind of firms?
    Yeah, expect the market to favour the companies with strong balance sheet, while those with huge loads of debts on their books are likely to be penalised. The best placed will be those companies that are able to finance their growth out of internal resource generation.