When I first became a financial journalist, one of the principles hard-wired into the system for analysing securities was something called “the reverse yield gap”.
This held that the yield on equities would always be lower than that on government bonds because, unlike bonds, equities offered a hedge against inflation. It was a principle that held good for well on 50 years, and was a surprisingly difficult mentality, once engrained, to shake off.
Many, therefore, missed out on the long bull market in government bonds. The cult of equity continued to hold sway for much longer than it deserved. But it was not always so, hence the term “reverse” yield gap.
Before 1959, the norm was for equities to yield more than bonds, both in the UK and the US. Since the crisis began, we’ve reversed spectacularly back to the pre-1959 norm. The yield on gilts is now substantially lower than that on shares.
And indeed, in some respects, it is this norm which is the more logical. It is entirely rational at a time when investors fear deflation that the relative security of bonds should become overpriced, and that equity yields should be relatively higher to reflect the threat of a sustained collapse in dividends.
The big investment question for this year is whether the yield gap might again begin to close, or even reverse back to its pre-crisis state. In any case, one of the most fashionable calls among investment analysts right now is that at some stage in the next 12 months, we’ll see the start of a great rotation out of bonds and back into equities.
Certainly, it is quite hard to believe bond yields could sink any lower. But here’s a question. If everyone thinks government bonds are a bubble riding for a fall, how come it’s not already happened?
Growth and inflation are two sides of the same coin, so if you think there is some chance of a cyclical recovery over the next year, you’d certainly be selling bonds. Equities are already to some extent reflecting such an outcome, with some substantial gains over the past year.
So to bet on a significant rotation is also to bet on the return of growth.
Well, everyone hopes for the best, but beyond the bounce in equity markets, which may be more driven by hunt for yield than faith in rip-roaring earnings growth, evidence for it is pretty thin on the ground.
I’m perfectly prepared to believe that bond yields could rise a bit from present, historic lows, where they offer the absurdity of a negative real rate of return.
Indeed, I can even envisage 10-year gilt yields rising by as much as 100 basis points. But such a rise would only take them back to where they were a year ago.
A combination of continued financial repression and low growth means they are quite unlikely to correct much further any time soon.
This is not to say that equity markets won’t carry on rising. I’m anticipating quite a strong year for equities, supported by hunt for yield and slightly more positive sentiment as fears of outright economic disaster recede.
Best value will again be in emerging markets, where there is every prospect of decent growth, but even the S&P may test new highs.
However, many countries are going to find it very difficult to wean themselves off the present, low interest rate environment, for the irony is that any significant rise in rates in anticipation of higher growth, will, for high debt economies, only hammer them back down again. Hey ho.