The Jonathan Davis Column

GIVEN THE timeless appeal of the stock market, it is often easy to overlook the fact that it is not just shares that go up and down in value. At the very least investors need to keep an eye on what is happening to the other main types of investment assets - gilts, property and index linked securities - and what they are telling us about investment returns generally.

As it happens, there have been some interesting recent developments in all these different markets. Take the housing market, for example, which seems to be sending out all sorts of conflicting signals. The puzzle here - which has been exercising the Bank of England's monetary policy committee among others - is whether house prices are currently rising by around five per cent a year (which would be perfectly normal) or at roughly twice that rate (which would set alarm bells ringing).

The two house price indices followed by most economists are produced by Halifax and Nationwide. The trouble is that they are both giving out competing signals. Since the end of 1996 the Nationwide series has consistently produced higher figures for house price inflation than the Halifax series. Its most recent figures suggest that house prices are rising at around 12 per cent per annum, against the five per cent recorded by the Halifax.

The reason for the discrepancy appears to be either a purely technical one (based on the way the two indices are calculated) or a reflection of the different lending characteristics of the two lenders. Halifax is much stronger in the North of England than Nationwide, and one possibility is that the divergent trend is telling us only that house prices are simply rising faster in the South - something which appears to be borne out by all anecdotal and other evidence.

Whatever the reason, it is something which could have a bearing on the cost of your mortgage. The Bank's monetary policy committee, which sets interest rates, is known to be concerned about the impact which rising asset prices could have on consumer demand and future inflation. The strong performance of the stock market over the last three years is one concern, but the housing market is even more important a component of national wealth - and any suggestion that it was getting overheated would reinforce the case for raising interest rates as a pre-emptive strike against future inflation.

The current state of sentiment in the gilts market is also a factor in future mortgage costs. For while short term interest rates are rising, long term interest rates (as measured by the price of gilts) continue to weaken, furthering the long downward march of the last few years. The importance of this trend is that most fixed rate mortgages are funded by gilts while variable rate mortgages tend to track changes in short term interest rates.

The difference in cost between fixed and variable rate loans therefore tends to reflect the difference in short and medium to long term interest rates. So do not be surprised, for example, if the next few weeks see a flurry of attractive looking fixed rate deals.

Before signing on, however, it is worth remembering that the reason fixed rate loans will look so attractive in cost terms is because longer term interest rates are falling - and if the markets are correct to assume that interest rates will come down over the next two to three years, as gilt prices suggest, then as variable rates start to come down the less valuable your fixed rate will actually be over that period.

Only if you have good reason to believe that the fundamental trend in interest rates is upwards are you really likely to benefit from a fixed rate loan in economic terms. The most obvious reason for thinking that interest rates are set to rise over the next 2-3 years is if you have a gloomier view of inflation than the market is currently incorporating. That would not necessarily be wrong - inflationary expectations have been falling steadily for a number of years, and that could well change before too long.

One sidelight on future inflation prospects is given by the performance of index-linked gilts, which I recommended two years ago, and which have since performed very strongly. They have proved very popular with institutional investors in the last couple of years. Here too, however, there are puzzles. As the chart shows, the yield on index-linked gilts has fallen to under three per cent.

It means that index-linked gilts are now yielding well over 0.5 per cent less than their equivalent in the United States, even though most experts agree inflation in the States is much more under control than it is over here. (Perhaps because index-linked bonds were introduced in the States for the first time last year and investors are just becoming used to valuing them).

Another oddity is that shares have, for most of this year, yielded even less than index-linked gilts, reversing the traditional relationship, and apparently defying the logic of investment theory which suggests that shares - as the riskier asset - should provide the greater return.

My take on all this is that these conflicting signals tell us more about the overvaluation of the stock market than they do about the inherent attraction of index-linked gilts at these prices. What is clear is that the policymakers in both the US and the UK are becoming concerned about the valuation of the stock market. The monetary policy committee of the Bank of England, in the minutes of its May meeting, allowed this classic piece of obfuscation: "The negative skewness in the FT-SE probability density functions has increased recently, reflecting a greater probability attached to a sharp fall".

What it means is that they think shares are likely to fall - which, if it happens, will probably sort out the valuation anomaly with index-linked gilts, and quite possibly help to bring the Halifax and Nationwide house price indices back into line as well.

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