Commentary – Quarterly bulletin, April 2009

While this indicates that equities are attractively valued on a long term basis, the income generated from an equity portfolio may well decline in the short term as companies divert cash elsewhere. An equity yield higher than the gilt yield used to be the norm based on the extra risk involved in equity investment. But since the 1950s, equities have been priced to allow for future growth in dividends over the long term and, as a result, the dividend yield has been less than the gilt yield, until recently. This relationship should be restored at some point when companies indicate that they are prepared once again to increase dividends.

Policy actions have raised the risk of higher inflation in a few years’ time.

The large amount of money being injected into the global economy is helpful at present. But later, when the financial system is once again capable of acting normally and borrowing picks up, this money will present an inflation risk unless it is withdrawn.

The Bank of England and other central banks are no doubt aware of this but the timing is crucial. If too early, the economy may lurch back into recession, particularly if the effect of the Bank selling the bonds it previously bought in its quantitative easing is to raise the cost of borrowing again. If too late, inflation psychology may take hold and it will be difficult and costly to purge it as we found in the 1970s and 80s.

Bond investors will be on guard and we can expect more volatility when the time for action comes. In the expectation of a slow recovery from a deep recession, that time is likely to be years rather than months away.

Equity markets have rallied strongly since the start of March.

Investors have been encouraged by some better economic news from a variety of countries to buy risk assets, especially equities. While the strength of the equity rally has been impressive, it is too early to think that a new bull market is underway. Issuance of new stock is still running at a high level and there could well be some digestion problems at times.

And while the markets are now discounting a sharp fall in profits this year there is scope for more bad news on the economic front to cause further downgrades. We need to remember that this recession is inducing some structural changes which I referred to last quarter and which are likely to stretch the normal cyclical recovery patterns. It is therefore more likely that equity markets will remain volatile for a while yet.

Corporate bonds have not yet reacted as positively as equities to signs that the global economy may be stabilising.

Nevertheless, the gap between gilt yields and corporate bond yields has started to narrow. As the year progresses and confidence grows that default rates can be contained, corporate bonds investors should benefit from further credit spread narrowing as well as the high income yield currently available.

As mentioned above, the massive monetary stimulus we have had in the past year has created an inflation risk. Investors see that as a distant prospect but nevertheless the inflation risk premium built into the pricing structure of the gilt market is nudging higher again. The supply of new fixed-interest bonds, from both the private and public sectors, is limiting the more positive effect on markets that quantitative easing was designed to achieve.

As a result gilt yields have been tending to rise again after the initial dip when the Bank of England started to buy. Index-linked gilt yields on the other hand have been stable or tending to decline, partly because of lower supply than in the fixed-interest sector and partly because of demand from investors reinvesting proceeds of the sales of fixed-interest they have made to the Bank.

It seems to be a game of pass-the-parcel!

— Ken Forman

Ken is an investment business consultant who spent 30 years as an analyst and portfolio manager at Standard Life Investments.