Comment: Cautious Nineties shun equities

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If this recession has made a radical change in consumer and business attitudes, it surely should also be making a radical change in investor attitudes.

It is now widely appreciated - even the Treasury appreciates it - that the econometric models of the economy do not work very well. They failed to predict the severity of the recession, largely because they failed to take into account a change in consumer attitudes. Consumers are not only much more cautious than they were two or three years ago; they are more cautious than they ought, on previous experience, to be at this stage of the economic cycle. Businesses, too, reacted differently to this recession than to previous ones: they cut back faster. As a result, the recovery is much slower than the Treasury expected, and the mandarins, along with all the other professional economists who relied on computer print-outs, made asses of themselves.

The people who got the economy right were either the paid-up members of the monetarist tendency, who could see deflation clearly in the money numbers, or those who worked on intuition, using that to interpret the anecdotal evidence from businesses and consumers.

Of course, investors are people too. If you apply either the monetarist or the intuitive approach to explaining investment attitudes, a rather different picture emerges from the 'battered bull' stance of most of the large securities houses. Most securities houses are still expecting the FT-SE 100 share index to be between 2,800 and 3,000 by year-end. Their arguments come at varying levels of sophistication, but behind them is a presumption that the rule still holds that equities will continue, most years, to yield more than either gilts or cash. The large institutional investors would seem to agree: they have a very high proportion of their funds in equities at the moment, typically 80 per cent of the sterling portfolio.

Slump danger

The monetarist case against equities is essentially that the very low growth of the money supply worldwide indicates that we are in a period of deflation of asset prices. There is some danger of a world slump. While that danger may not be large, it does exist, and accordingly investment in cash and bonds is much safer than investment in companies' shares.

One does not need to buy the full version of this thesis to see that there must be some merit in it, simply in terms of a shift in the risk/reward ratio against equities. Interestingly the team at the Bank Credit Analyst in Montreal, the investment advisers who have probably been using monetary data to interpret investment trends for longest, has now turned bearish on US equities. Their July commentary gives a clear 'sell' signal for the first time this cycle, although the numbers have been turning bearish for some months. UK share market values are much better than US (and better now than a couple of months back thanks to the fall in the market) but it would be difficult for them to perform well if US share prices were heading south.

But this is a rather mechanistic approach to investment. What of the psychological change in fund managers? They are not in the same position as either consumers or business people, in as far as the problem of both these groups is an excess of debt. The institutions are not borrowers: precisely the reverse, so there is no direct parallel. There is, however, an indirect parallel. Caution rules.

Caution stops consumers buying and it makes business people cut back at the slightest sign of trouble. Caution makes investors want to lock into acceptable returns, rather than take the risks inevitably involved in going for greater ones. This would not, of itself, constitute a case against equities, but it would make fund managers worried about over-exposure, and it would certainly keep the small investors away from new issues, the main direct way in which personal savings come into the market.

This caution can go some way to explaining the behaviour of share prices since the election. It certainly explains why there has been hardly any retail interest in issues like The Telegraph. It also explains why new issues in general are very difficult. There has been no wholesale move out of equities by the professional investors, but their new cash is being earmarked for fixed-interest securities, of which there is a plentiful supply. The Government needs to sell a lot of gilts to fund the deficit, but it happens to suit the investment institutions to buy these for it enables them to rebalance their portfolios.

Seismic shift

They are doing this because they have (or the more thoughtful of them have) a nasty, nagging feeling that the whole investment game may be about to go through one of those great seismic shifts that occcur once a generation. Norwich Union caused a bit of a stir last year when it let it be known that it was shifting the balance of its portfolio towards fixed-interest securities. It may or may not have got its timing right, but the fact remains that in the first six months of the year, bonds in the UK yielded nearly twice as much as equities.

Whatever view one takes, there is certainly a big equity/fixed-interest debate going on in the City, which raises a further question: could the very fact that the cult of the equity is being questioned itself undermine share prices? Supporters of equities can always argue that if you smooth the fluctuations equities will eventually come out on top. A note from James Capel this week points out that the final quarter of the year is often a strong market and that it would not take a lot for the markets to reawaken to the prospect of a worldwide economic recovery.

But there is a danger of institutions staying out of the market simply because they see other institutions staying away: the herd instinct that drove them into equities would keep them out of them. Under those circumstances, it would be hard for share prices to move ahead.

The big issue, though, is not what happens in the autumn to share prices. It is whether the ideal portfolio of investments for the 1990s will be more like the typical portfolio of the 1890s: a base of gilts, a selection of high-yielding bonds including some foreign ones, some equities that are bought for yield rather than for capital gain, and some gold. It would have been a catastrophe to have had that sort of portfolio in the Eighties, but, as is now very clear, the Nineties are a different matter.