Commentary – Quarterly bulletin, July 2010

28 July 2010

At the beginning of this year there was a strong consensus that gilt yields would rise and that equity markets would continue to trend higher, albeit at a more moderate pace than we saw in 2009. With the rally during July, equities are just about back to where they started the year but gilt yields have fallen sharply since then. Recent market behaviour suggests investors have become more complacent about the state of public sector finances and inflation while vacillating about the state of the corporate sector. There seems to me to be good reason to challenge this complacency with regard to gilts while investors seem to be ignoring an underlying improvement in the health of the corporate sector. But the risk of a more prolonged period of falling gilt yields and weak equity markets has risen as a result of policy tightening in the UK and elsewhere.

Is the past a guide to the future?

Over the 22 years* to 2009 the annual returns for equities, gilt and property markets in the UK have differed by less than 1% p.a. and have each beaten inflation by between 5% and 6% p.a. Figure 1 shows the path taken by each over the period, as well as by the retail price index. Equities have been the most volatile and it is the choice of end date that makes the results so close. It is generally accepted that equities and property are riskier investments than gilts and for that reason investors should earn a higher long-term return from them. There is no evidence of this in Figure 1, so what’s been going on? Back in 1987, gilts were priced cheaply relative to the inflation experienced since then. Yields have since fallen significantly as investors’ perception of the inflation outlook improved. This created windfall capital gains for gilt investors and boosted the return over the period towards what was achieved by investing in equities and property.

The situation today is very different.

Gilt yields now reflect the view that inflation will average under 3% p.a. for the next decade and beyond. If this continues to be the case, the gilt return will be modestly more than inflation. To achieve a higher return, inflation expectations would have to reduce further on a sustainable basis, which is asking a lot given the way the monetary printing presses have been working in recent years. If inflation expectations rise, gilt prices will fall and returns will be less than the current yield. Equity valuations, by contrast, are similar to where they were in 1987 and are less sensitive than gilts to changes in inflation expectations. From current valuations (which are neither excessively high nor low) we can expect the return from equities over a long period to be determined more by growth in profits and dividends than by a change in the valuation. This suggests that returns will be significantly higher than inflation. The outlook for property is similar to equities and perhaps even better given that the current valuation (yield) is noticeably higher than average. But remember that these are long-term expectations and that markets can deviate from the script for decades at a time!

During the second quarter, equity markets suffered the biggest shakeout since the recovery started last year.

However, in the context of the previous rise it was still a relatively normal correction. Investors were influenced by a series of unsettling developments including the Euro-zone crisis and indications that economic growth may be faltering before we have had a full recovery. Nevertheless, corporate news continues to be relatively positive. Earnings are recovering well and companies are embarking on another round of capital investment, particularly on productivity enhancements, which bodes well for future profitability.

Most equity markets have for some time now had an inverse relationship with bonds.

That is, when bond prices rise (and yields fall), equity markets tend to fall. It used to be the opposite, with equity markets rising in response to lower bond yields on the basis that you could discount future earnings or dividends at a lower rate and therefore justify a higher price. Now the driving force seems to be risk appetite. When investors’ perception of risk rises, they will switch from equities and other more volatile assets to what they regard as safe havens (primarily government bonds, although they have become more discerning over which government!). Figure 2 shows the relationship between UK equities and gilts over the past 22 years. Eventually, once the ripples from the financial crisis die out, the old relationship should be restored. But without the downward trend in bond yields we had in the past, the old relationship is unlikely to be as pronounced. In the meantime, bonds are acting as a good diversifier within a balanced portfolio at a time when equity markets are likely to remain volatile.

Investors have driven ‘safe-haven’ bond yields ever lower in the past few months.

Investors have been reassessing their definition of ‘risk-free’ safe havens in recent months, prompted by the fiscal challenges in Greece. So far, the UK, US, German and Japanese markets are still deemed to fall into the safe haven category despite considerable public sector financial strains in these countries. This has pushed 10-year yields in the UK and US down towards the lows set at the end of 2008 and in the case of Germany to a new record post-WWII low. The 10-year gilt now looks expensive on anything other than a very low inflation or deflation scenario. The speed of its decline in recent months has been relatively extreme and it would not be unusual for there to be at least a partial reversal in the short term. Corporate bond yield spreads have given back some of their fall in the rush to safe assets and there is scope for them to resume their decline once risk appetites improve again. But any contraction in the spread from here on is likely to be more than offset by a rise in the underlying gilt yield.

* This is the longest period for which there is reliable and continuous date for the UK commercial property market.

— Ken Forman

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