We are returning to a duller and more traditional investment climate - returns are less exceptional but more predictable ...fear of inflation is indeed beginning to fade

INVESTMENTS

Most ordinary investors are now aware that there is an influential school of thought which believes that inflation is a dragon that has been well and truly slain. The question that now needs asking is whether investors have yet to come to terms with the fact that, if this school of thought prevails, the historically high inflation-adjusted returns they have experienced on most types of investment in the last 15 years are not going to be sustained in the future.

According to a comparative study by brokers BZW, over the last 10 years equities as a class have produced a total return in real terms (ie after inflation) of 10 per cent per annum. This is comfortably above the long- run average of 7.3 per cent. The return for someone who pays the highest rate of tax has been proportionately better - 7.9 per cent a year over the 10-year period, compared to a long-term average of 3.2 per cent.

The returns from gilts have also been exceptionally good by past standards. The total return over the last 10 years has averaged 6.8 per cent in real terms, against a long-term average of just 1.5 per cent. Though prices of gilts have fallen in more years than not, the loss in capital value has been more than offset by the high rates of interest that the Government has been forced to pay to persuade people to lend it money for any length of time.

Even the return on cash has been extraordinarily good in historical terms - 5.2 per cent per annum in real terms over the last 10 years, against the long-run average of around 1 per cent. It is now a remarkable 16 years in a row that cash has offered a positive real return.

However, this has passed many ordinary savers by. For what BZW, in common with most professional investors, regards as cash is not what most people think of as cash. The brokers look at the returns offered by Treasury bills, which is short-term Government borrowing, and the nearest thing around to a risk-free investment.

BZW chronicles graphically how poor by comparison the returns on bank and building society deposits have been. It is only recently, as ordinary savers have started to learn the merits of shopping around, that banks and building societies have been forced to pay more to look after people's money.

The interesting point that BZW makes, however, is that the trend of higher- than-average real returns which began in 1980 is now clearly beginning to reverse. For all three asset classes, though returns remain comfortably above the historical average, the margin is narrowing. At the same time, there is some fairly clear evidence that the risk of investing in both equities and gilts as a class is returning to more normal historical levels. The wild swings in prices that were experienced in the 1970s increasingly look a thing of the past. This is what you would expect given the scale of the massive economic disruption and the uncertainty created by the oil price crises of that time.

All this is consistent, therefore, with the view that we are returning to a duller and more traditional investment climate, in which returns are less exceptional, but more predictable, than before. It implies that fear of inflation is indeed beginning to fade as a factor in investor perceptions.

Investors generally have put a higher value on company earnings than in the past, and as a consequence most of the exceptionally higher returns from shares we have seen has come from capital appreciation, rather than from dividend income.

As far as gilts are concerned, the picture is less clear-cut. If inflation can be kept within a band of 0 to 4 per cent, the outlook for gilts will remain pretty good, but it is not the only factor that impinges on gilts performance.

Government borrowing is still high by historical standards the world over, and until the campaign for smaller government starts to produce concrete results, investors are going to remain leery of funding huge deficits.

The final interesting thought promoted by the BZW study is that the re- rating of equities we have seen in the last few years will eventually go too far and need to be corrected. BZW's evidence shows that on some bases the valuation of the market is already high by historical standards, but it suspects - rightly, I think - that it will be some time before this is fully recognised or reversed.