Forecasting which investment avenues offer the greatest attraction in the new decade is a seductive pastime. Yet, making long-term predictions is complex and there is no greater certainty in forecasting at the turn of a decade than at any other time. Regardless of the starting point, forecasting always is a difficult issue.
Notwithstanding this caveat, there are things that one can anticipate with a greater degree of confidence than others, given the behavioural traits of investors and the likely impacts on and responses of capital markets. For instance, there are aspects of history that repeat themselves, and one of these is asset price bubbles.
Although asset bubbles recur with surprising frequency, no one has ever built a career out of predicting them: investors seldom like a party pooper. What is more, it can take years before a bubble bursts, making the predictions of collapse look increasingly foolish, despite their ultimate accuracy. A good example of this was Alan Greenspan's 1996 remark relating to "irrational exuberance" in his effort to describe the massive inflation that he saw in stock prices at the time. Yet, it was only four years later that the bubble in technology stocks did burst.
In short, it is particularly hard to predict when a bubble will collapse. They exist because people have the propensity to behave irrationally - often for long periods - and it is almost impossible to determine when the crowd will come to its senses.
Against this backdrop, while the late "noughties" experienced spectacular asset price collapses, it is far from clear that the excesses have worked their way out of the system. Notwithstanding that the recently collapsed property, credit, emerging market and commodity bubbles brought the world to the brink of economic depression, my sense is that there are at least two more bubbles on the horizon.
The first is sovereign debt. The primary risk to investors in the 1990s was that of emerging market debt defaults. In the noughties, companies presented the greatest default risk. In the teen decade, the risk is that developed countries will default.
This threat is the consequence of a range of factors. The governments in advanced economies have taken on unmanageable levels of debt, which, in itself, is a form of asset bubble. The unfortunately termed Pigs (Portugal, Ireland, Greece and Spain) fall into this category, as does Iceland. But there are much larger economies, with far greater levels of debt, which run the risk of sovereign default.
The most notable cases are the three largest economies, namely the US (where the national debt to gross domestic product ratio is likely to be more than 100 percent by the end of this year), Japan (about 200 percent) and, to a lesser extent, western Europe (where some economies display ratios well above manageable levels, such as Italy's 110 percent). In this cluster, though, it is the UK that stands out.
Bill Gross, from Pacific Investment Management Company, contests that the country's sovereign bonds are "a must to avoid. High debt with the potential to devalue its currency present high risks for bond investors."
It must be added that not only are the debt ratios alarmingly high, but also, in many cases, serviceability is going to become increasingly difficult as populations in these regions "go grey", which means fewer workers per pensioner, shrinking workforces and reduced tax bases.
From this, there is a range of implications for investors during the next decade. One is that investors should think carefully before lending money to an advanced economy's government. The graph above shows that the average credit default swap spread on European government debt (represented by the iTraxx SovX Western Europe index) is now close to that of the region's major investment-grade corporate debt issuers (iTraxx Europe index).
In short, buying advanced economy government bonds is unlikely to be a risk-free exercise in the new decade.
A second perceptible investment risk comes in the form of China, where asset bubble attributes are increasingly evident. Some of the more obvious aspects are: reported economic growth is exceptionally strong (10.7 percent for the fourth quarter of last year and 8.7 percent for the full year); and analysts see the country as having extraordinary prospects, to the extent that China will change the world. This gives China a "this time is different" characteristic which, in itself, should be treated as an alarm by investors.
There is an expectation that this economic growth and change will continue unabated, and that China is a one-way bet which can only succeed. This view is reinforced by the expectation that China will overtake Japan this year to become the world's second-largest national economy.
Moreover, credit growth in China is rampant. Loans rose by a record 9.2 trillion yuan (R10.2 trillion) in the first 11 months of last year. The year-on-year increase in credit is more than 30 percent.
Finally, some assets are expensive. For example, the Shanghai composite index is trading on a price:earnings ratio of more than 30 times one-year trailing earnings. If earnings are normalised using a 10-year average, the ratio is more than 50 times, triple the globally accepted safe level.
Property in the country's capital city is changing hands at a price-to-rent ratio of 500 times and price-to-income ratio of 27 times. This compares with the global red lines of 300 times and 5 times, respectively. To put this into perspective, it is like buying a Joburg property that attracts a monthly rental of R10 000 for R5 million. Anecdotally, the Chinese island of Hainan has seen property prices rise by as much as 50 percent in a few weeks and the average property price gained 18 percent in the 10 days to January 20. Although this is a tiny part of the picture, it suggests frenzied speculative buying which, if unchecked, will spill over into other asset classes.
While China may be growing fast, it is a mistake to confuse economic growth with investment success. China will change the world, of that there is little doubt. But this fact does not mean that investing in China will be the route to financial success.
In short, the price that investors are willing to pay for exposure to China is too high. Not unrelated to this point, we also know that GDP growth and investment returns are negatively correlated. Over investment periods, high economic growth correlates with low investment returns.
The current high levels of government debt globally mean that investors must equip themselves for higher inflation than in the noughties. Experience shows that some asset classes are reasonably well placed to deal with this.
Portfolios that hold physical and productive assets are better equipped to deal with the debt, deficits and potential default than the purported safe haven asset classes of cash and government bonds. Investors should put a question mark over any exposure to debt that they may have.
Equally, not all productive assets will translate into investment success, China being an obvious example. If it looks like a bubble, feels like a bubble and floats like a bubble, it probably is a bubble.
Adrian Saville is the chief investment officer of Cannon Asset Managers and holds a visiting professorship in economics and finance at the Gordon Institute of Business Science. Visit his blog at http://www.adriansaville.com.