I've been ploughing a lonely furrow in recent years by keeping faith with the "cult of equity". Despite the strong rebound in equities since the invasion of Iraq, the flow of institutional money is still strongly into bond markets. For demographic and regulatory reasons, few expect that trend to reverse any time soon.
It's therefore refreshing to see the global equities team at HSBC challenging the new orthodoxy in a lengthy recent circular, "Equities: It's About Time". Put simply, their thesis is that equities are not as risky as they are made out to be over the long term, and that for pension funds hoping to match assets against long-term liabilities, they may actually work rather better than bonds.
This is because the great bulk of bonds are not of sufficiently long duration to provide a match for many, long-term pension fund liabilities. Moreover, there is an insufficiently large supply of bonds for them to meet the demand, with the result that yields may already have been depressed to artificially low levels.
The last decade has been one of extreme volatility in equity prices, with shares soaring to record levels before plummeting back down again. Investors became correspondingly more risk averse, a trend that was accentuated by the fact that many defined-benefit savings schemes in the US and Europe were maturing. At the same time, prospective payout periods were lengthening with increased longevity, causing the present value of future liabilities to rise.
The downward path of real interest rates made the cost of servicing these liabilities greater still. Regulatory and accounting changes further increased the pressure on pension funds to achieve a better match between present assets and future liabilities. As HSBC puts it, "the combination of shockingly high equity risk with an increased need for investor security killed the cult of equity". As regulators, trustees and accountants rushed to prevent further damage, there was a wave of forced selling of equities, causing prices to fall still further. There was also panic buying of bonds, causing yields to fall ever lower.
Equity weightings tumbled as investors opted for the apparently safer haven of bonds. When regulators start dictating the investment strategy, you can be pretty sure it will eventually turn out to be deeply flawed, and unless we are about to enter a period of global deflation it's virtually certain that's the case with the present pursuit of bonds.
Nobody knows where share prices will be 20 years from now, though the strong likelihood is that they will be quite a bit higher. What we do know, however, is that in some shape or form most larger companies will continue to be in existence. According to the HSBC analysis, more than two thirds of the businesses backing large cap UK equities in 1984 are still out there in some guise, and actually the great bulk of them still hold title to the original business. Very few have failed outright. In nearly all cases, the owner still has title to cash-generating business assets.
With a portfolio of gilts, on the other hand, the failure rate would be zero, but very few bonds that are trading today will still be in existence in 20 years time. What's more, the risk to value from rising inflation and interest rates remains high. Nor can any pension fund manager know exactly what his liabilities are going to be. If longevity increases beyond present predictions - more that possible - a portfolio of assets invested entirely in bonds still won't cover the enhanced liabilities. On the other hand, there is a good possibility that a well managed portfolio of equities would. Fashion can be a dangerous thing when applied to investment. The present fashion for bonds seems an even more dangerous craze than most.
Echoes of the Co-op in Regan's RSA tilt
Andrew Regan, the swashbuckling financier who once made a bid for the Co-op, refuses to be put down. Less that two years after being acquitted on charges of theft and bribery, he's back making headlines, this time with a mooted bid for Royal & SunAlliance, one of Britain's biggest insurers. Mr Regan always was much better at getting himself in the press than pulling off deals, and unfortunately for him that's all too likely to be the case with Royal & SunAlliance too. The chances of his AIM quoted vehicle, Corvus Capital, even mounting a bid for RSA, let alone it succeeding, are close to zero.
Still, where there's a will there's sometimes a way and Mr Regan shouldn't altogether be discounted. He managed to make a bid for the Co-operative Wholesale Society back in 1997 despite the fact that it was co-operatively owned, and although it all ended in tears, leading eventually to his own trial over events that took place some years previously, he did manage to assemble an impressive array of backers for the endeavour.
One of them, Hambros Bank, was fined by regulators for using stolen information about the Co-op in the bid. Hambros never recovered from the reputational damage so inflicted and was eventually taken over itself. It seems a little unfair on Mr Regan to drag all this up so long after the event, but he could hardly be surprised by it. For Mr Regan to bid for RSA, fallen on hard times though it has, through such a tiny company as Corvus would be an undertaking just as audacious as his assault on the Co-op.
Mr Regan is probably right in thinking RSA undervalued. Andy Haste, the chief executive, has done a creditable enough job in restructuring the enterprise after the disaster of the Bob Mendelsohn years, but the ultimate size of the company's asbestos and other insurance liabilities in the US, which are in run-off, remains largely unknown. If they are as limited as the company hopes, then RSA would indeed be a snip at the present valuation. The fact that they might be a good deal higher makes it quite unlikely bankers would back Mr Regan's plans. And if all he intends to do is offer equity in Corvus, Mr Haste could swat the Regan interest away as easily as a fly.
Mr Regan would be well advised to learn to swim once more with some smaller deals before again attempting the thrill of the high diving board. Look what happened last time.
A banking merger for Brits to watch closely
UniCredito's takeover of HVB will again concentrate minds among British bankers on the merits or otherwise of a consolidating European merger. Up until now, the British majors have steered clear of Europe in the belief that the cultural and legal differences are too great to make them work to the advantage of shareholders.
Royal Bank of Scotland Group has concentrated instead on America, HSBC on the US and the Far East, Standard Chartered on emerging markets, and so on. Even Barclays, which a few years ago bought into the Spanish banking market, has since focused its global pretensions elsewhere in the world. Of the majors, Lloyds TSB came closest to doing a big European merger, but as ever in these cases, powerful egos got in the way.
Maybe it's time to think again. The UniCredito deal displaces Lloyds TSB from the top ten banks globally by market capitalisation, and if the cost savings and synergies are as big as the Italian bank claims, then there's plainly more value to be extracted from cross-border consolidation than hitherto imagined.
The risks are obvious. The claimed savings require deep cuts in HVB's German workforce, which given the present backlash against labour market reform in Germany, may or may not be possible. No one's got a clue what the bad debt position of these German banks really is, since most of Germany's dodgy corporate debt is unrecognised, and although UniCredito is making much of HVB's position in Eastern Europe, the great bulk of its business is still in Germany, whose economy remains becalmed. Food for thought, none the less. UniCredito's progress will be keenly watched from these shores.Reuse content