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The End of the Equity Cult?. Duncan Gwyther Chief Investment Officer October 2010. The End of the Equity Cult. Two significant bear markets and continuing high volatility Uncertainty over economic growth prospects Regulation designed to make ‘the world a safer place’ - Solvency 2 etc Mean

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the end of the equity cult

The End of the Equity Cult?

Duncan Gwyther

Chief Investment Officer

October 2010

the end of the equity cult1
The End of the Equity Cult
  • Two significant bear markets and continuing high volatility
  • Uncertainty over economic growth prospects
  • Regulation designed to make ‘the world a safer place’ - Solvency 2 etc

Mean

  • Global bond yields have fallen to multi-decade lows, and
  • Insurance sector’s equity allocation just 4% (net of policyholder participation)
  • Bond fund flows are now greater than equity flows were in 2000

But

  • Sovereign debt crisis is real and ongoing
  • Inflation isn’t dead, so is there a ‘real’ problem meeting future liabilities?

Source: Investment Company Institute, Morgan Stanley European Strategy 27 September 2010

equity exposure uk insurance companies

Association of British Insurers

Long-Term and General Insurance Holdings

Cash and Other

UK Public Sector Securities,

Investments, 8%

12%

Property, 6%

Overseas Public Sector

Securities, 6%

Unit Trusts, 13%

UK Ordinary Stocks and

Shares, 15%

Other Overseas Company

Securities, 14%

Overseas Ordinary Stocks

Other UK Company Stocks

and Shares, 15%

and Shares, 11%

Equity exposure - UK insurance companies

Source: Association of British Insurers 31 August 2010

equity exposure uk insurance companies1

Morgan Stanley Research

Estimate of Net Policyholder Participation

Cash, 5%

Equities, 4%

Other, 10%

Govt Bonds, 30%

Loans, 8%

Str Credit, 11%

Cov Bonds, 5%

Corp Bonds, 27%

Equity exposure - UK insurance companies

Source: Company data, Morgan Stanley European Strategy 27 September 2010

fund flows pension funds structural sellers
Fund flows - pension funds structural sellers

Source: WM Pension Funds 31 Dec 2009

fund flows us equity mutual fund flow v performance

Net Fund Flows to Equity Funds Relative to Global Equity Performance

40

50

40

30

30

20

20

10

10

Billions of Dollars

% Total Return on Equities

0

0

-10

-10

-20

-20

-30

-30

-40

-40

-50

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Net new cash flow

% Total return on equities

Fund flows - US equity mutual fund flow v performance

Source: Investment Company Institute and Morgan Stanley Capital International 2010

fund flows us bond mutual fund flow v performance

Net Fund Flows to Bond Funds Relative to Bonds Returns

2.5

20

2.0

15

1.5

1.0

10

0.5

Billions of Dollars

% Total Return on Bonds

0.0

5

-0.5

-1.0

0

-1.5

-2.0

-5

1995

1996

1996

1997

1997

1998

1999

1999

2000

2000

2001

2001

2002

2003

2003

2004

2004

2005

2006

2006

2007

2007

2008

2008

2009

Net new cash flow

Total return on bonds

Fund flows - US bond mutual fund flow v performance

Source: Investment Company Institute and Morgan Stanley Capital International 2010

government debt debt swap now a public problem

European Commission Forecasts for

Budget Deficit v General Government Debt in 2010

14%

United Kingdom

12%

Ireland

10%

Spain

Greece

Portugal

Budget Deficit, % GDP

8%

France

EU

Euro Area

6%

Italy

Germany

4%

Sweden

2%

0%

20%

40%

60%

80%

100%

120%

140%

General Government Debt, % GDP

Government debt - debt swap now a public ‘problem’

Source: European Commission

government debt initial debt is not the whole story
Government debt - initial debt is not the whole story

% of GDP

Source: EU commission, Eurostat, CBO, IMF, Morgan Stanley Research 25 Aug 2010

government debt revenue available to repay debt matters
Government debt - revenue available to repay debt matters

Source: Eurostat, CBO, Morgan Stanley 25 Aug 2010

government debt so how safe are sovereign bonds really
Government debt - so how safe are sovereign bonds really?
  • Sovereign debt crisis is global
  • Private to public debt swap has to be ‘paid for’
  • Increased taxes will raise sufficient revenue to cover the bill
  • Default
    • UK/English government has not defaulted on debt since 1594
    • Other countries have
    • Gilts rank senior to all other government debt
  • ‘Financial oppression’
    • Reneging on ‘unsustainable promises’ - pensions are an obvious target
    • Repaying debt in devalued money e.g. through unexpected inflation
    • Regulating institutions to purchase government debt at uneconomic prices
  • No insurance against financial oppression at current yields
inflation money supply in real economy contracting

14/10/10

18

16

14

12

10

8

6

4

2

0

-2

O

N

D

J

F

M

A

M

J

J

A

S

O

N

D

J

F

M

A

M

J

J

A

S

O

UK MONEY SUPPLY M4 - 12 MONTH CHANGE SADJ

Source: DATASTREAM

UK 12M GROWTH RATE OF MFI STERLING NET LENDING EXCL.SECURITIS

Inflation - money supply in ‘real’ economy contracting
inflation uk long term expectations still well anchored

14/10/10

5.00

4.50

4.00

3.50

3.00

2.50

2.00

1.50

1.00

0.50

2006

2007

2008

2009

2010

UK YOUGOV/CITIGROUP-INFLATION EXPECTATIONS FOR THE NEXT 12 MONTHS

Source: DATASTREAM

UK YOUGOV/CITIGROUP-INFLATION EXPECTATIONS, NEXT 5-10 YEARS

Inflation - UK long-term expectations still well anchored
equities excess equity return determined by dataflow

14/10/10

80

10

8

60

6

40

4

20

2

0

0

-2

-20

-4

-40

-6

-60

-8

-80

-10

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

EXCESS UK EQUITY RETURN OVER 6M ROLLING PERIODS

Source: DATASTREAM

OECD LEADING INDICATOR,6M CHANGE R/H SCALE

Equities - excess equity return determined by dataflow
equities unlike governments companies have plenty of cash
Equities - unlike governments, companies have plenty of cash

European companies have plenty of cash

Source: MSCI, Worldscope

900,000

20

Cash on balance sheet

Cash as % market cap - rhs

800,000

18

Cash as % total assets - rhs

:

700,000

:

16

600,000

14

500,000

12

Cash as % of Market Cap/Total Assets (%)

Cash on Balance Sheet (€m)

400,000

10

300,000

8

200,000

6

100,000

0

4

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Source: Morgan Stanley European Chartbook 7 October 2010

equities company cash flow is strong

Cash flows are cheap to buy

10.0

Source: FactSet, Datastream, MSCI, Worldscope, IBES, Morgan Stanley Research

8.0

6.0

4.0

2.0

FCF Yield for MSCI Europe (%)

0.0

-2.0

-4.0

-6.0

-8.0

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010e

Equities - company cash flow is strong

Source: Morgan Stanley European Chartbook 7 October 2010

equities company balance sheets are strong

Corporate balance sheets are strong

2.4

75

Source: FactSet, Datastream, MSCI, Worldscope, IBES, Morgan Stanley

2.2

70

Net debt to equity - rhs

2.0

65

1.8

60

1.6

55

Net debt to equity

Net debt to EBITDA

1.4

50

Net debt to EBITDA

1.2

45

1.0

40

0.8

35

0.6

30

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010e

Equities - company balance sheets are strong

Source: Morgan Stanley European Chartbook 7 October 2010

equities companies ready to splash the cash
Equities - companies ready to ‘splash the cash’?

Source: Morgan Stanley European Chartbook 7 October 2010

equities uk dividend corporate bond yield ratio
Equities - UK dividend/corporate bond yield ratio

Source: Citi Research European Portfolio Strategist 19 August 2010

equities uk equity earnings gilt yield ratio
Equities - UK equity earnings/gilt yield ratio

Source: Citi Research European Portfolio Strategist 19 August 2010

equities cheaper than corporate debt m a

14/10/10

13

12

11

10

9

8

7

6

5

4

3

2

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

10

GILT YIELD

CORP BOND AAA

Source: DATASTREAM

FTA 500 IND EARNINGS YLD

CORP BOND BBB

Equities - cheaper than corporate debt = M&A?
equities components of uk total return

30%

20%

10%

0%

-10%

-20%

-30%

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

20

YTD

YRS

ANN

Income return

Capital growth

Equities - components of UK total return

Source: FTSE All Share, DataStream, to end 21 September 2010

the end of the equity cult maybe not
The End of the Equity Cult - maybe not
  • Governments will grow their way out of the unsustainable debt position
  • Default unlikely, ‘Financial oppression’ almost a certainty
  • Regulation mean institutions set up to be the ‘fall guys’
  • Inflation may be tame short-term, but it is NOT dead longer term
  • Structural investor selling will continue to dampen equity returns
  • Equity valuations provide a large risk premium for future uncertainty
  • Companies will take advantage of the valuation anomalies through M&A
  • Dividends provide shorter-term ‘reward’ for ‘carrying’ the risk
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Disclaimer

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