Hamish McRae: We don't like it - it's far too quiet. But that doesn't mean there'll be a market massacre

A curious calm has pervaded the financial markets in recent weeks. Shares have edged higher, we seem a little less concerned about rising interest rates, the currency markets have been quiet. Behind this calm lie the long-running worries about the environment, oil prices, the potential instability caused by global imbalances and so on. But on the surface, at least, all is fine.

At a time like this, the most helpful thing is to try to take the long view: how might our present circumstances appear in a historical context? As it happens, the latest Global Investment Returns Yearbook from ABN Amro was published last week, giving a rear-view mirror perspective on the returns of different asset classes since 1900 - a long enough perspective for most of us.

It has several messages - some obvious, some less so. The most obvious is that shares continue to be a vastly better investment than fixed-interest securities or cash. As you can see from the left-hand graph, the total return from British equities in nominal terms since 1900 has been just under 10 per cent, which is almost exactly the same as the equivalent return on US shares. By contrast, fixed-interest securities and cash or near-cash (three-month bills in this instance) have struggled to keep ahead of inflation.

This calculation assumes that dividends are reinvested, which in practice would be difficult for most investors because dividends are taxed. Capital gains alone would give an average return of around 5 per cent - a little higher in the US, a little lower in the UK - so these are barely ahead of inflation.

The calculation also assumes interest payments would be reinvested, again something that would be impossible for most holders. So in practice, anyone saving in the other asset classes would have probably lost money in real terms.

Moral: invest in shares (or maybe property) and do not put your money in bonds or hold it in cash.

If you look at the past year in its historical context, it rather fits the long-term pattern. Shares in all major markets including the UK had their fourth year of rising prices. By contrast, the return on fixed-interest securities in most countries was flat in nominal terms and negative in real terms.

Most people who follow shares will be up to speed on all this. More surprising, I found, were two other facts. One of these, which I had only been half aware of, was that since 2000 small company shares have done better than big company ones in every country bar Norway. Moral: small is beautiful.

The other fact, which I had not been aware of at all, was that the last bear market, the end of the technology boom, was far worse for shares than either the First or Second World Wars.

The right-hand graph shows the overall impact of the five worst bear markets of the last century, together with the impact on the country worst hit. Thus German shares did worst out of the 1914-18 war and Japanese ones out of the 1939-45 war. That is hardly surprising. Nor is it surprising that US shares did worst out of the Wall Street crash of 1929 , or British equities out of the first oil shock of 1973 (remember, that was when we had the highest inflation in the major economies).

What is surprising, though, is that Germany did worst out of the end of the technology boom and that - viewed overall - the two world wars were not too bad for share prices.

Now, the ground lost in the 2000-02 bear market has been recovered - indeed more than recovered if you invested in small-cap companies. So what happens next?

Well of course the past is no guide to the future ... except, in a funny way, it is. That share prices will continue to rise each year for the next four years, as they have in the past, is extremely unlikely. There has been no unbroken increase of eight years in the past 100 years.

On the other hand, it is equally unlikely that we will see another bear market similar to the 2000-02 crash in the next decade, maybe longer. There have, after all, been only five such crashes in more than a century.

So given all this, what can sensibly be said about the present calm? I think the big point here is that markets are back to normal in the sense that the trauma of the ending of the dot-com boom is past. However, four new factors, absent from previous cycles, are influencing their behaviour.

The first is the huge wave of global liquidity created by the long period of cheap money and by rising Asian and Middle Eastern savings. The second is that much of this new money is controlled by "new" investors - in the Middle East, Russia and so on.

The third is that the old mechanisms of the public markets - the markets that this study reports on - are being bypassed, with the money seeking private equity routes instead. And finally, a lot of new instruments are on the market and the buyers of these may not fully understand the risks involved.

Taken together, these new factors make people uneasy. Viewed historically, there have always been elements like these in the markets. In the first years of the last century, the new factor was European investment in Russia - and The Tsarist bonds that savers flocked to buy became worthless. But then it would have been hard for investors in 1907 to foresee the Russian revolution. However, as that right-hand chart shows, whatever the dreadful human consequences of the First World War, its impact on global equities overall was not that great.

So we are right to be uneasy and particularly right to be uneasy about classes of investments where risk is opaque. There is, as it happens, one type of investment in the US that has suddenly appeared much more risky than holders thought. This is "sub-prime mortgages", with sub-prime being a euphemism for rubbish - mortgages on which the holders are more likely to default. The value of these has fallen by around 20 per cent in the past three months, with much of the fall in the past couple of weeks.

Now to anyone who has been following the US housing market, it was pretty obvious that a lot of mortgages would be in trouble. When you have lenders allowing people to borrow 110 per cent of the value of a property on an interest-only basis, any fall in house prices will lead to trouble. But investors did not see this coming.

Lots of other investments will be less secure than the holders think and it would be perfectly within historical experience for a few such instances to unsettle share prices more widely. But that does not imply a global crash in the near future. Ask yourself this question: can you see anything as serious as a world war, or as mad as the dot-com boom, on the horizon?

I hope your answer is no.

Year of the Pig offers golden opportunity

Today is the start of the Chinese New Year, the year of the pig, traditionally a propitious year for investment. And not any old pig. Apparently, it is the year of the Golden Pig, which occurs only every 60 years and is accordingly even more propitious than the regular sort. Maternity hospitals all over China are expecting a boom in business, as parents try to have a baby this year.

But will it be good for investment? The Shanghai stock market certainly boomed at the end of last year but in recent weeks prices have come back quite a bit with investors taking profits. This year is likely to see a series of financial market reforms that may further promote equity investment. These include opening up banking to more foreign participation and deregulating prices in a number of areas, including energy. It looks like another year of 10 per cent growth, which will underpin company profits. The trouble is that Chinese share prices move independently of the Chinese economy. They lagged far behind for many years, in marked contrast to India's markets, and only in the past year have they shot ahead. The obvious worry is that the year of the golden pig will create a speculative bubble that will lead to economic damage further down the line.

Does this matter to the rest of us? Well yes, in two ways. First, expect a flood of UK and US-based investment propositions. That is already happening. And second, expect the Chinese current account surplus to be invested more widely in Western markets. So the ripples of the China market boom are likely to be felt in other markets round the world. The tail of the pig will, so to speak, wag the rest of the animal for the next 12 months.

Then comes the Olympics next year, so expect the boom to race on till then. After that, who knows?

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