Faculty of Actuaries Students’ Society Current Topics – Investments March 2009 Authors: Euan G Munro FFA Jason M. Hepner, CFA Contents 1. Introduction ............................................................................ 3 2. Equity Markets ....................................................................... 6 3. Government Bonds................................................................. 9 4. Corporate bonds.................................................................... 12 5. Real Estate ............................................................................ 14 6. The FX markets .................................................................... 15 7. Commodities......................................................................... 17 Disclaimer Any views or personal opinions expressed in this paper are those of the author, and not of Standard Life, FASS, the Actuarial Profession, or any other body (unless specifically stated). The author takes responsibility for any errors or omissions. Neither the author nor any related party will be liable for any direct or indirect losses incurred as a result of actions taken or not taken on the basis of information contained in this paper. Nor does the author or any related party take responsibility for the content of external links. 2 Investment Markets in 2008 1. Introduction There are landmark years in the lives of those who operate in the financial markets. 2008 was one of those years. Equity market events tend to be high profile, and so for example even non-market people will often be aware of the Black Wednesday crash of 1987, and will have been conscious of the dotcom bubble and its subsequent three year deflation. The foreign exchange market has also had its moments. Mischievous Labour politicians love to remember, and Conservative politicians would like to forget, Black Monday – the day when Sterling came crashing out of the European Exchange Rate Mechanism in 1992, dropping around 15% against the Deutsche Mark overnight. Bond markets tend to be a specialist subject and so probably only bond managers will remember (with considerable pain) the bond market crash of 1994, which followed hard on the heels of a multi-year bull market which had culminated in astonishing returns from long dated bonds in 1993. What marks out 2008 is the breadth of the distress. Few market segments have been left unscathed. The root problem was that an era of readily available and cheap credit came to a screeching halt. Harbingers of the value destruction witnessed in 2008 had been seen in 2007. By mid 2007 it was widely recognised that some banks had been lending irresponsibly in the US sub-prime mortgage market. However, by the autumn the failure of Northern Rock intimated that the credit/liquidity crunch was impacting on the UK. As 2008 unfolded it became widely recognised that the entire banking systems’ profitability and willingness to lend depended on them being able to securitise their loan books and finance themselves cheaply in the wholesale money markets. As neither of these two were practical possibilities in 2008, the banks stopped lending, creating a vicious cycle as businesses and individuals unable to secure short term borrowing facilities ended up either actually defaulting, or looking much more likely to do so. Banks reported enormous losses, and it became clear that the entire Global banking system would require significant recapitalisation. The extent of the collapse in the value of bank share prices in 2008 is helpfully underscored visually by Exhibit 1.1 which shows that major global banks have shrivelled in value to be a shadow of their former selves. (Acknowledgements to JP Morgan for this helpful image.) 3 Exhibit 1.1 4 Such uncertainty created an appalling atmosphere for risky assets. On the other hand, the anticipation that to avert depression pro-active central banks would cut their interest rates led to significant rallies in world bond markets. This combination of falling risk assets and declining bond yields has made 2008 a very difficult year for pension funds and individual investors seeking to provision for long dated liabilities. Exhibit 1.2 shows the contrast between the total return on bonds in a number of geographies, and the total return on equities. Readers should bear in mind that liabilities will have typically behaved as a leveraged exposure to bonds (because they are longer in duration). Few asset portfolios behaved like that! 130 120 110 100 90 80 70 60 50 40 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total return of asset classes (rebased): European Equity US Equity German Bonds US Bonds Exhibit 1.2: Bond versus equity total return comparison The intention of this paper is not to provide an almanac of all the information and data pertaining to markets in 2008, for that I reference Google. It is rather to draw out some of the key themes that emerged in the past year in the major asset classes. However, I have added (appendix 1) the returns to a Sterling investor of investing in a wide variety of cash, bond, equity and property benchmarks over 2008. The eagle eyed reader will notice from the appendix that there is a huge disparity in the returns in 2008 due to currency. For example, Japanese equities, to the £ Sterling investor, did not fall by much at all. Similarly, bond market returns were ‘skewed’ by FX movements, for the UK based investor. We discuss these huge FX movements in Section 6. 5 2. Equity Markets 6500 Weak economic data points to prolonged global downturn 6000 Lehman bankruptcy 5500 Congress rejects TARP Bear Stearns rescue 5000 Fed cuts 125bp in two weeks (no equity reaction) 4500 4000 UK bank bailout 3500 Citi bailout , MBS purchases initiated by the Fed 3000 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Exhibit 2.2: FTSE100 throughout 2008 Global equity markets fell by around 40% on average in local currency terms but spread in a range from 25% to around 50%. Full details of returns to a sterling investor are included in the market return appendix. Exhibit 2.1 shows how the FTSE100 responded throughout the year to a number of significant pieces of market news. Following a sharp fall at the start of the year, the market enjoyed a brief period of relative stability - helped by the US Federal Reserve cutting interest rates by 125 basis points. However, markets fell again on poor economic and corporate data, finding a local bottom after the US authorities decided to bail out the troubled investment bank Bear Stearns on 17th March. This triggered a bit of a relief rally over the next several months but ultimately gave way through the summer after continuingly poor economic data and the realisation that Bears Stearns was not the only bank with problems. The equity market focus quickly moved to trying to identify the next most vulnerable financial institution. There were plenty of targets! September saw a period of extreme volatility. The two US agency mortgage businesses - Fannie Mae and Freddie Mac - had to be rescued by the US government on the 7th, Lehman Brothers revealed a $3.9bn Q2 loss on the 10th and after the failure of rescue talks declared bankruptcy on 15th. The shot-gun marriage of Merrill Lynch to Bank of America was announced on the same day. During the following week the 6 Reserve Primary money market fund broke the buck (i.e. priced the fund at less than par, recognising losses on their ‘high quality’ money market investments). This was key. This was the moment that the market began to realise that AAA rating was not always as it seemed. This was a frightening prospect for many investors. AIG was rescued by the US government, and in the UK Lloyds TSB announced a takeover of HBOS. Investors pride themselves on being able to absorb and discount lots of information and uncertainty quickly, but this was just too much, too quickly and the policy responses seemed to be on the hoof and inconsistent. The market needed some reassurance and fast; and high hopes were placed on the US TARP (Troubled Asset Relief Programme) - a $750bn plan to buy bad assets from banks and allow them to repair their balance sheets. Equity markets including the UK crumpled when the US House of Representatives rejected the TARP bill in October. Markets bottomed as the US and UK announced a banking sector bailout involving capital injections into major banks and the equity markets appeared to find some stability into the close of the year. By November 2008, the market had fallen so sharply, that it had ‘priced in’ much of the bad news. 120 110 100 90 80 70 60 50 40 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec S&P FTSE TOPIX Latin America Index Exhibit 2.2: There was little benefit from international diversification Exhibit 2.2 demonstrates that the equity market weakness was broad based and largely indiscriminate in local currency terms. There was a period where emerging markets (Latin America is used here as a proxy) appeared to be immune from the negative sentiment in the more developed world. The rationale for this was a 'decoupling' argument that swayed market sentiment in the first half of the year. The argument constructed was that China could continue to grow despite the dramatic slowdown in US demand and would still be a huge consumer of the raw materials exported from Latin America in particular. This belief caused a large spike in 7 commodity prices, in mid 2008 the cost of filling up the car’s fuel tank became oppressive for many families, it also caused the Emerging Market and especially Latin American markets to outperform. In a similar vein, what strength had been seen within developed market equity indices, had in early 2008 been in energy and material sectors. ‘Long Commodities’ versus ‘Short Financials’ was a favoured trade by many, including much of the hedge fund community, in the first half of 2008.