Back to the 1950s for the yield gap?

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The Independent Online
The 'air pocket' that shares around the world fell into at the end of last week has revived the spirits of the equity bears: not yet exactly vindication, for the bears still expect further falls, but confirmation that other investors are getting the message.

If the fall of last week was little more than a blip, it has coincided with other evidence of caution. For example, the Smith New Court/Gallup survey of fund managers this week shows that for the first time since the survey was started in 1990 British fund managers do not intend to increase their holdings of UK equities. That in itself is hardly surprising given the perceived opportunities in Continental Europe but it does suggest a slightly more sceptical attitude to UK equities in general.

Among the UK-based fund managers the most consistent anti-equity, pro-bond investor has probably been Pyrford International. This was originally established by Elders IXL, the Australian brewer, in 1982 and was bought out by the management in 1991. It is now based in London.

By chasing the great bond run of the last three or four years it has produced very good results: although equities have had a fine bull run, this has been the one bull market in equities that has been associated with an even stronger bull market in bonds. This has helped the bond-heavy managers, for in contrast to most UK fund managers, which are 60 to 80 per cent invested in equities, it has been only 35 per cent in equities and selectively at that.

Now that its rather extreme house view has become a little more fashionable, it seemed a good idea to check with its managing director, Bruce Campbell, on its view of markets now.

Pyrford is still looking for a sharp fall, 25 per cent or so, in both the US and the Japanese equity markets and is not in them at all. London shares are better value, but could still face a 15 per cent-plus fall. Continental Europe? Not so concerned, and still a buyer of equities there. Elsewhere in the world, Pyrford sees value in the Asia/Pacific region, with markets such as Malaysia and Australia still being attractive, although the run in Hong Kong has brought its value down from good to fair.

In bonds, Pyrford is not now a buyer in the US, but feels there is value at the very long end of the spectrum in Britain, Japan and some Continental markets, such as the Netherlands.

It is worth setting out this view because it is not at all the conventional London investment position. The intellectual core of the Pyrford position is that we are still in the quite early stages of a process of disinflation that will last a generation. That is why it is a buyer of bonds at the very outside edge: anyone feeling that gilts that mature in 2017 are good value is making a tough assumption about inflation rates in the intervening period.

If this is right, and there is another generation of disinflation ahead, then the rules of investment of the inter-war and early post-war period are more appropriate than the rules of the 1970s and 1980s. Between 1926 and 1956 there were 30 years when gilts on average gave about three-quarters of the yield on equities. The cross-over in yields came in 1959. After a period of violent swings in the 1960s and 1970s, when gilts yielded between one- and-a-half and three times equities, the gap settled down and through the 1980s the yield on gilts was twice that on equities.

The Pyrford argument is that any valuation based on a 10-year view - the view of what was normal during the 1980s - is irrelevant. We should go back earlier. If inflation remains very low, bond yields ought to fall to the 3-5 per cent range that was considered normal. And equity yields should rise to the 4-6 per cent band that, again, used to be regarded as normal. With British equites now yielding a little below 4 per cent, they are dear.

Well, that is the bear case. What might be wrong with it? There are at least two respectable counter- arguments.

One is that inflation will resume. It will not be the double-digit inflation of the 1970s and early 1980s, but it will be high enough to be significant - about 4 per cent on average for the OECD nations during the 1990s, and not the 1 or 2 per cent (with periods of falling prices) of the inter-war and immediate post- war period.

The other is that profit growth is still very positive. Companies are developing new technologies and new working practices much more quickly than ever before and so will be able to improve profits much more quickly than in the past. This will enable dividend growth to continue quite rapidly, which will in turn underpin equity values.

If either of these is right, while there may well eventually be a return to the pre-1959 yield gap, it will not be for another few years, maybe a decade. Pyrford will eventually be proven right, but at the moment it is ahead of its time. And if both are right, then the case for equities will be intact for the foreseeable future and Pyrford is wrong.

(Photograph omitted)