This month marks the 10-year anniversary of the start of the global financial crisis, an event triggering the most serious downturn in global growth since the great recession of the 1930s.
UK GDP fell by around 6 per cent in the following year. Investors were hit hard, with UK equities falling by 46 per cent in the aftermath and global equities by 38 per cent.
The global economy is now firmly in recovery mode. UK activity is 12 per cent higher than its previous 2007 peak, while the FTSE All Share index is some 68 per cent above its earlier high.
Investors who stayed in UK equities throughout the downturn and recovery have earned an average annualised total return of 6 per cent for the whole period. Those who invested at the bottom of the market in 2009 have received a juicy 14 per cent per annum.
There is no doubt the aggressive policy stimulus followed by governments and central banks played a significant role in reducing the length and depth of the recession.
Early in the crisis, coordinated fiscal policy expansion boosted economies in developed countries, particularly the US and the UK. That stimulus petered out because of worries about excessive levels of government debt, especially in Europe. As a result, the main burden of stimulus fell to central bankers.
When textbooks become reality
The Bank of England, US Federal Reserve and European Central Bank cut interest rates to zero and, in some cases, beyond. All of those central banks turned to unconventional monetary policies previously confined to economic textbooks.
This involved quantitative easing, often referred to as “money printing” but more accurately defined as buying government bonds in an attempt to stimulate asset prices, bank lending and confidence.
Generally, these unorthodox policies were successful, even if they have led to worries about the implications of sustained low interest rates and whether borrowers will be exposed when interest rates start to rise.
On the cusp of change
Investors should be aware of the changing stance of central banks but they should not become too pessimistic.
The need for emergency policy stimulus is disappearing because the global economy is faring much better, even if the situations in the US, the euro area and the UK are rather different.
The Fed is now gradually raising interest rates and preparing the market to unwind its earlier QE. This is appropriate, as spare capacity in the US economy has been eliminated, unemployment is low and inflation is near target.
By contrast, inflation in the euro area is below target and expected to remain so. For that reason, ECB spokespeople emphasise they will continue to add to policy stimulus, albeit at a slowing rate (probably cutting their monthly rate from €60bn to €40bn, perhaps down to zero by the end of 2018).
Prospects in the UK are clouded by Brexit, which carries considerable downside risks to activity, complicated by the one-off boost to inflation caused by the sharp decline in sterling last year.
How should you react?
So, 10 years after rates plummeted, how should you respond to the prospect of normalising economic policy?
Firstly, recent political events clearly illustrate the difficulty of investing on the basis of prediction. Since mid-2016, the path has been littered with pundits’ predictions of a Remain vote in the UK’s EU referendum, a Clinton victory in the US elections and a weak coalition government in France.
Secondly, the past year has shown the benefits of staying globally diversified. UK investors who were overweight domestic assets (as the majority are) have fared badly compared to portfolios with a globally diversified strategy.
Thirdly, recent history illustrates predictions of a bond market rout have been premature. Although bond returns are likely to be subdued, there is still a role for fixed income to provide a stabiliser and to act as a counterweight to equities.
Peter Westaway is chief economist for Europe at Vanguard