The spectre striding the globe is deflation. And the more we debate it the closer it comes
IT IS FUNNY how quickly sentiment in a market can change. If we are not yet in rampant bear market mood, we seem to be heading that way fast.

Suddenly, everywhere we look there seems to be bad news. This week President Clinton himself, temporarily (at least) still the most powerful leader in the world, took time off from his local difficulties to inform us that we are facing the worst potential financial crisis since the Second World War.

On Monday the leaders of the G7 nations discussed how best to confront the real risk of a financial meltdown and George Soros, no less, warned that the capitalism itself was at risk from the current upheavals in Russia and the Far East.

Nearer home, the so-called "flight to quality" in financial markets continues. It was marked this week by the yield on UK gilts falling to their lowest level in 30 years. Even though bonds issued by our Government now are priced to yield little more than 5 per cent, they continue to look attractive to global investors looking for a safe haven from perceived risks in most emerging markets. (Brazil, South America's largest economy, this week became the latest country to face a potential market collapse).

In fact, an interesting thing is happening to the gilts market. Even though we have been living through the greatest bull market in stocks this century, gilts - long a pariah by comparison - have actually been producing as good, if not better, returns. As my chart shows, the total returns produced by gilts and equities over the last nine years have actually been pretty similar.

Against the long term historical record, and in a country where inflation is consistently higher than in many other of our peers, this is positively startling. The long run trend is for equities to produce substantially higher real returns than gilts - 7 per cent against around 2 per cent over the past 50 years. The assumption that shares are the better bet continues to underpin investment strategy. But in a disinflationary world, it has proved to be an unreliable assumption.

Government bonds are a traditional haven for investors when economic contraction threatens. The spectre which is striding the globe is clearly one of real deflation - a world in which the value of money declines from one year to the next. It now seems clear that interest rates in the United States and this country have peaked. The issue now is whether we are yet at the point when Mr Greenspan decides it is necessary to start cutting interest rates aggressively.

The more the world debates this issue, the greater the risk of course that it will take place. As the elegant American financial writer John Rothchild advises in his brilliantly-timed new book about bear markets, the best thing an investor can do is to switch off the TV and chuck away the newspaper. That way at least, you don't get contaminated by the self- propelling momentum of a market feeding on its own anxiety.

Most advice that comes out of professional investment houses at such times sounds as certain and self-confident as ever, but masks a fundamental and painful fact: that nobody actually knows how long and how deep the current changes in economic reality and market sentiment are going to be. That leaves the way clear for the market to be driven by gut feelings rather than logic.

An obvious response to gathering market gloom is to do what investors around the world are now doing, to pull money out of riskier assets - which include emerging markets and equities generally - and switch into bonds and cash.

Anyone who plumped for cash over shares in 1966 might have looked foolish four years later, but not so dumb for most of the rest of the succeeding 20 years. In fact, it would have taken until 1986 for the guy who stuck with shares in 1966 finally to overtake the cautious cash saver.

The case for bonds is more complex historically. Sometimes they prove a better home than shares when bear markets develop; sometimes they are a lot worse. A lot depends on inflation. If it resurfaces, as it did horrendously in the 1970s, bonds of all sorts get taken to the charnel house.

If it is dead or dormant, then bonds can show equities a clean pair of heels for a while. That is clearly the scenario which seems most appropriate today. On that view, there is still scope for gilts yields to fall further, remarkable though that would be.

I notice that Crispin Odey, one of the UK's best hedge fund managers, is expecting Europe's stock markets to come off by 30 per cent, then rally, then fall sharply again. Most bear markets, he says, retrace half the gains they have made since the bull market began, and a really bad one loses 80 per cent of what has previously been gained. 1998, he concludes, is going to be "a difficult year" for anyone expecting to demonstrate their bull market skills. I agree.

`The Bear Book: Survive and Profit in Ferocious Markets' by John Rothchild (John Wiley)