By Satyajit Das
In 2012, despite slowing growth, deepening sovereign debt problems and lacklustre earnings, equity markets advanced strongly. In 2012, the MSCI All-Country World Index of equities increased 16.9 per cent in 2012, including dividends.
Twenty three out of 24 benchmark indexes in developed markets increased. The US S&P 500 Index climbed 13 per cent, the highest increase since 2009. European markets rallied with Greece, Germany and Denmark increasing almost 30 per cent. Only Spain's IBEX 35 fell but only by a modest five per cent. Despite its embalmed economy, Japan's Nikkei 225 Stock Average rose 23 per cent in the largest rally since 2005.
Bonds of all types returned around 5.7 per cent on average. Safe haven buying and demand for yield increased, fuelling demand for bonds. Ever lower interest rates and risk margins did nothing to discourage buying.
Despite continued debasement of currencies through central bank quantitative easing, the S&P GSCI Total Return Index of 24 commodities rose 0.1 per cent.
Highlighting the perversity, even debt of beleaguered European nations was in demand. Astute investors doubled their money on Greek bonds, in a surreal bet on an economically-dead nation incapable of paying backs its debt.
Investors could easily delude themselves into thinking that "happy days" have returned. But there has been a marked shift in the investment climate. Decent returns can be still earned during periods of great uncertainty. They just require different investment approaches.
Investment outcomes are now influenced more by government and central bank policy decisions than fundamental factors. The rally in the euro and European bonds and stocks following the European Central Bank's announcement that it would purchase unlimited quantities of peripheral country debt demonstrated the risk of misreading policy.
Major central banks dominate markets. Their collective balance sheets have increased from around $6 trillion before the crisis to more than $18 trillion, an unprecedented 30 per cent of global gross domestic product (GDP).
Government and central bank strategy is targeted at growth and creating inflation using non-conventional monetary policies, quantitative easing and specific inflation targets. High nominal growth would make existing debt levels more sustainable. Inflation would help reduce debt in real terms. But the strategy may not work.
While central banks are providing ample liquidity, the effects on credit creation, income, economic activity and inflation are complex and unstable. The velocity of money or the rate of circulation has slowed. Banks are not using the reserves created and money provided to increase lending, reflecting a lack of demand for credit by stretched households and businesses with over capacity. The reduction in velocity offsets the effect of increased money flows and limits the pressure on prices.
Uncertainty about the effectiveness of policy complicates investment choices.
If policy makers succeed in restoring growth with modest inflation, then equities may prove the best investment. If the policies result in high or hyperinflation (such as that experienced in Weimar Germany or Zimbabwe), then real commodities and precious metals such as gold may be the best investment to protect against the erosion of the value of paper money. If the policies prove ineffective, then a period of Japan-like stagnation may result. In such an environment, bonds or other fixed income instruments will be the favoured investment.
In recent times on a number of occasions, equities, bonds, commodities and gold have rallied simultaneously reflecting investor confusion.
For investments denominated in foreign currencies, the effect of loose monetary policies on currency values is an increasingly important influence on investment returns.
There will be increased interference in financial markets, as governments intervene, overriding normal market mechanisms. Prohibitions on short selling, bond purchases and currency intervention are examples.
Governments bonds are no longer risk-free safe havens. The risk of default or loss of purchasing power either through devaluation of currency or diminution of purchasing power is prominent. As Jim Grant of Grant's Interest Rate Observer observed government bonds now offer "return free risk".
Risk premiums are frequently negative as investors flock to safe assets or the latest bestest investment - US and German bonds, high-yield corporate bonds or high dividend stocks.
Diversification to mitigate risk is difficult, since correlation between different investment assets has become volatile. The fundamental risk of domestic shares, international shares and property is similar in the current economic environment. Even returns on cash are positively correlated to risky assets owing to the fact that interest rates have fallen in the recession.
Investors assumed policy measures have reduced tail risk, the chance of large and frequent increases and decreases in prices. In fact, the opposite may be true. Attempts to suppress volatility, without addressing fundamental problems, increases the risk of major market breakdown in the future.
Imitation may be the best investment strategy. As Bill Gross has repeated frequently during the crisis, Pimco buys whatever central banks are buying. It is like the scene from When Harry Met Sally when a woman having watched Meg Ryan fake an orgasm in Katz's Delicatessen tell the waiter: "I'll have whatever she's having".