Secrets Of Success: First a hi-tech bubble. Now a house-price slump?

T he hardest thing in the world to achieve when pontificating about money and markets is to strike the right balance between the short-term outlook for different kinds of investments (something akin to weather forecasting, and as reliable) and the longer term, but more important, forces that will shape the climate of investment over the next 20 to 30 years. If you get the latter right, there is far less need to spend time worrying about the former.

One of those who has managed to hit the button successfully in recent years with his analysis of longer-term issues for is the economist Roger Bootle, whose words I have been reading since he started out years ago as the gilts market analyst at the specialist broking firm of W Greenwell.

Mr Bootle now runs his own consultancy firm, Capital Economics, and while well-known to professional investors for his regular analysis of the markets, made his biggest splash in the wider world seven years ago when he published an influential book called The Death of Inflation. In it, he advanced the thesis that, contrary to conventional wisdom at the time, the forces bearing down on inflation all round the world were much more powerful than most people realised.

As a result, he argued, inflation would remain subdued for much longer than most investors assumed and might even tip over into outright deflation. This would have important implications for policymakers and investors.

Specifically, it meant the risks of investing in fixed-interest securities would most likely be much smaller than consensus thinking at the time allowed. As inflationary fears receded, interest rates would inevitably continue to fall, generating capital gains for all holders of fixed-interest securities such as gilts and corporate bonds. This is exactly what has happened. Although equities continued to produce spectacular double-digit returns through the final years of the great speculative bubble of 1995-2000, the returns from bonds not only matched them during that period, but have continued to outperform.

The disappearance of inflation as a credible immediate danger is a perfect example of a broad change in the investment climate that you need to get right if you are to have the best chance of getting your finances sorted out over the course of a lifetime.

The most interesting thing, to my mind, about Mr Bootle's new book, Money for Nothing (Nicholas Brealey), is that he is now trying to call a couple more important secular changes in the investment climate.

His argument, first, is that the risk of deflation - a long and sustained period of falling prices - is now very much a real one and one central bankers are going to have to work very hard to prevent. "The world is at a critical juncture, poised between a surge in wealth and descent into outright slump", is how he sums up the argument at the outset of the book. Related to this is his view that we have not yet paid the full bill for the insane share-price bubble of three years ago, which convinced many people they were wealthier than they are.

The fallout from the bubble has had huge impact on the value of the pension funds on which many people's retirement depends. The value of the with-profits funds held by UK life companies, he says, fell by £50bn in 2002 alone, equal to £1,000 for every person in the country. It will take time for the ramifications of this dramatic change in wealth to be felt.

Mr Bootle thinks it is unlikely returns from the stock market will get close to what they achieved in the 1980s and 1990s, and may struggle to top 4 per cent per annum on average over the next decade. (There may well come opportunities to do materially better than that out of shares if the market falls further, and moves from being overvalued to undervalued, as is quite likely in his view).

The second big theme of Mr Bootle's new book, one clearly designed to send shudders of apprehension through Middle England, is his view that house prices may now follow share prices and start falling sharply. The double whammy of lower stock market returns and falling house prices could, he fears, be the trigger that sends the economy into a slump.

His argument is that the wealth generated by steadily rising house prices is just as much an illusion as the wealth apparently created by the stock market boom.

"Just as in the share boom, hundreds of millions of people have thought money would cascade to them from rising house prices, without effort or desert, merely by sitting there, money for nothing. But a society can no more get rich through rising house prices than it can through everyone agreeing to take in each other's washing," he writes.

So is he going to be as right about this as he was about inflation? Although the residential property market has clearly started to slow, the evidence that prices are to fall is equally not visible. Yet he makes strong points to support his argument that there are similarities between the housing market today and the stock market of three years ago. In particular, the rationalisations used to justify property investment now have become dangerously detached from reality.

The mantra used by many housing market bulls is "affordability", arguing that low interest rates make it justifiable for house-buyers to borrow what would otherwise be considered dangerously high multiples of income. This argument is in turn used to enable such people to make higher bids for property than they could otherwise contemplate.

The pin that will eventually burst that bubble is, of course, higher interest rates. Significant increases in interest rates today seem as remote as 3.5 per cent inflation would have been 20 years ago. But we can rely on higher rates returning. The trouble is that incomes are not rising rapidly enough to give borrowers the financial muscle to cope with that development.

The key point is that a combination of 20 years of anti-inflationary policy and two bubbles, one in shares, the other in housing, threaten to change the climate for investors over the next 20 years. All of us need to work out how best to come out on the right side of the equation. The only consolation is that all secular changes of this kind, by definition, do not play out overnight, so there is time to try to work out an effective riposte.

davisbiz@aol.com