History can be a useful guide to align expectations of equity and bond market volatility to help stay the course.
Equity declines 1800-2000
- The historical evidence reflects about a 30% real loss in equities over 2-3 years occurring about every 10 years. This is the median real loss and duration of stock market declines from 1800 to 2000 in the US and UK. Over this period there were 17 significant declines in the UK and 20 in the US which equates to about once every 10 years. Single event loss were larger, as in the case of UK equities which declined by about 75% between 1971-74.
Stock Market Crashes, Productivity Booms, Busts and Recessions: Some Historical Evidence
- There have been about 250 sovereign defaults in the last 200 years, most in emerging economies, according to Reinhart and Rogoff– with some combination of ‘can’t pay, won’t pay. They find that advanced industrial economies, with longer traditions of public borrowing and deeper financial markets, have a higher degree of ‘debt tolerance’. For example, the UKs debt/GDP increased to more than 250% as a result of financing wars, and with low repayment capacity at the time, which subsequently declined to lows of about 40%. Japan’s debt/GDP ratio is about 230%, double the US. Inflation played a role in reducing the UK’s large debt burden (from 1915-20 UK inflation averaged 17% per year).
Reflections on the Sovereign Debt Crisis
- In some cases, hyperinflation has destroyed the value of bonds (e.g. Germany 1922). Fifty two countries have experience hyperinflation at some point between 1900 and 2000. Most were developing countries but the list also included Germany and Austria 1922. The quantity theory of money provides some insights into the drivers of hyperinflation, it states MV = PY, money supply (M) x velocity of circulation (V) = price (P) x output (Y). A common view seems to be that the main source of (hyper) inflation is an increase in money supply (increase in M, and holding V and Y constant, P must increase). However James Montier (with historical examples – linked attached) provides a fairly convincing case that the root cause of extraordinary inflationary periods is a massive shock to output (a significant decline in Y, holding M and V constant, P must increase) (e.g. Germany 1922, Brazil 1987-1994, Zimbabwe 2007-09). Following this analysis, he seems more concerned about the risk of hyperinflation if there was a break-up of the eurozone (output shock precondition), than he is about the risk in the US, UK, and Japan.
Hyperinflations, hysteria, and false memories
- 1. US treasuries are still high quality in terms of financial ability to pay, relative to other sovereign debt (it is the flight-to-safety/liquidity option for fixed income).
2. Owning foreign bonds add their own risk. Default on external debt is more common than default on domestic debt (while there have been 250 cases around the world of defaults on external debt over the last 200 years, this compares with 68 defaults on domestic debt – Reinhart and Rogoff). Inflationary reductions in the value of bonds also seems more likely/significant in foreign bonds (particularly if there is any breakup of the eurozone).
Stay the course.
Robert
.