In 2012, despite slowing growth, deepening sovereign debt problems and lacklustre earnings, equity markets advanced strongly. The MSCI All-Country World Index of equities increased 16.9 per cent 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.
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.
The first months of 2013 have seen equity markets continue to rise. The Dow Jones last week passed its 2007 record high, while the FTSE 100 hit a fresh five-year high of 6,510.6, nearly double the 3,287 low it touched on 12 March 10 years ago.
Investors could easily delude themselves into thinking happy days have returned. But there has been a marked shift in the investment climate. Investment outcomes are now influenced more by government and central bank policy decisions than fundamentals. The rally in the euro and European bonds and stocks after the European Central Bank announced 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 soared from $6trn (£4trn) pre-crisis to $18trn – 30 per cent of global gross domestic product.
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 to reduce debt in real terms. But the strategy may not work. Uncertainty about the effectiveness of policy complicates investment choices.
If policymakers succeed in restoring growth with modest inflation, then equities may prove the best investment. If the policies result in high or hyper-inflation, then commodities and precious metals such as gold may be the best bet 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, when bonds or other fixed income instruments will be the favoured investment. For investments denominated in foreign currencies, the effect of loose monetary policies on currency values is an increasing influence on investment returns.
There will be increased interference in markets, as governments intervene. Prohibitions on short selling, bond purchases and currency intervention are examples.
Governments' bonds are no longer risk-free safe havens, with the risk of default or loss of purchasing power either through devaluation of currency or diminution of purchasing power. As Jim Grant of Grant's Weekly Interest Rate Observer says, 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 as 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 as interest rates have fallen in the recession.
Attempts to suppress volatility without addressing fundamental problems increase the risk of major market breakdown in future.
Imitation may be the best investment strategy. As Bill Gross has repeated frequently during the crisis, Pimco buys whatever the central banks are buying. It is like the scene from When Harry Met Sally as a woman having watched Meg Ryan fake an orgasm in Katz's Delicatessen tells the waiter: "I'll have whatever she's having."
Satyajit Das is a former banker and the author of 'Extreme Money' and 'Traders Guns & Money'