Keith Skeoch is one of the foremost readers of financial markets. In a career of over 40 years spanning top investment house James Capel and latterly Standard Life Aberdeen, he has lived through three separate returns regimes. In a new column for Citywire Amplify, he says a fourth regime is coming.

Throughout my career, an economic or financial crisis has felt increasingly like a hardy perennial.

These crises – and there have been more than 40 of them around the world since 1980 – come in all sorts of shapes and sizes. Some were largely local, such as the Finnish banking crisis in 1991. Some felt seismic at the time but had limited long-term consequences, such as the 1987 stock market crash. But some, such as the Asian and Russian crises in the late 1990s and the global financial crisis in 2008, had very profound impacts on everyone.

All were accompanied by noise and hype, which grew exponentially as communications media digitised. This has made it increasingly difficult for investors to distinguish critical signals about a change in the return environment from the seductive siren voices that lead to the investment rocks.

Amid the crises and crashes, the past 43 years have been characterised by only three different return regimes.

First, the long bull market in asset prices from 1980 to 1999. Second, the search for yield and reach for risk from 1999 to 2007. And third, the low-inflation, low-interest, slow growth with compressed but volatile returns that has characterised the past decade and a half.

Each of these regimes delivered different returns but also required different approaches to investment. Successful managers and brands adapted to the regime. Those that did not sometimes survived but were weakened; many more disappeared. Figuring out the impact of the current, so-called, crisis on the return environment is not just a matter of intellectual curiosity; for some, it may prove existential.

Return regimes are created through the interaction of three key forces:

• the economic fundamentals that define the path for interest rates and earnings growth;
• the regulatory framework that defines the investment opportunity set for large institutional investors;
• and the government policy setting that creates confidence in the stability and confidence in the longevity of the regime.

All three are showing signs of stress, sending a strong signal that the current regime is under duress and a radical change is underway.

Although the root cause is global – the rare combination of the pandemic and war in Ukraine – it is in the UK, where the stresses are most apparent.

The UK has a history of inflation vulnerability as financial markets have a relatively high weight in economic activity. Bond yields may be determined globally, but gilts help to shape world yields as well as being shaped by them. Confidence in government policy response is the lowest I have seen in the past 40 years, hence the visceral response across the yield curve.

I have been involved in economics for 50 years. A key lesson is that if fiscal and monetary policies are not well coordinated in the fight against inflation, interest rates end up doing the heavy lifting.

Interestingly, the last time the UK saw a serious shift to combat rising inflation expectations was in 1989. Then, short rates doubled in just over a year and nearly hit 15%. Like today, that came in the wake of a very expansionary Budget. That monetary tightening did help bring inflation back under control, but it took another decade to achieve price stability.

The UK’s financial system is also exhibiting some new and potentially systemic stresses as institutions reach for liquidity and deal with the volatility in the bond markets. Liquidity is locking up in the institutional and residential property markets and is a serious source of stress for pension funds.

Liability-driven investment is a misnomer: it is essentially cashflow matching through derivatives, which will always cause problems once there is a serious prospect of a sustained rise in interest rates.

I have long argued that a negative feedback loop results from the unintended interactions between three of the main modern macroeconomic and macroprudential policy building blocks: risk-based solvency, mark-to-market accounting and inflation targeting.

Each has a strong intellectual foundation, a persuasive case for its application in its own field, and an intuitive appeal. But combining all three, particularly when volatile market-based interest rates are used as discount rates, has unintended consequences. What we see is a toxic effect on the supply of institutional funds available for long-term riskier investments.

Paradoxically, creating an incentive to hold assets with a well-defined duration encourages a reach for yield. It provides credit, which increases vulnerability to inflation and interest rate shocks. Long-term investors have always known that risk-free rates and returns only exist on regulatory balance sheets – not in the real world. While bond yields may be the least volatile investment with one return regime, they can be highly volatile across different regimes. This is what the current generation of investors is rediscovering.

Where does that leave us? In the stormy water between return regimes while trying to avoid siren voices offering investment certainty.

The new return regime will not be visible until it is clear that inflation has been neutralised and a new structure of interest rates established. That requires the return of confidence in policy and some of the emerging systemic issues to be addressed, which is never a quick fix. Investments with a strong balance sheet and income derived from cashflows that are insensitive to interest rates with a strong management team look to be the best place to ride out the storm.

Keith Skeoch was James Capel’s chief economist and then managing director of international equities. He was then chief investment officer of Standard Life Investments, eventually becoming CEO of Standard Life Aberdeen. He chaired the Ring-fencing and Proprietary Trading review for HM Treasury and was the chair of the Financial Reporting Council and the Investment Association. He is currently chair of the Edinburgh International Festival and the advisory board at the University of Sussex Business School.