Hamish McRae: The switch into bonds from equities is on but is it a seismic shift?

The reallocation of weights between bonds and equities may move quite a bit further
Click to follow
The Independent Online

So that was the bottom of the interest rate cycle, or so it would seem. The questions now are how fast rates will rise and what are the implications of rising rates for world financial markets.

So that was the bottom of the interest rate cycle, or so it would seem. The questions now are how fast rates will rise and what are the implications of rising rates for world financial markets.

There has been quite a lot of new evidence in the past few days. Following the Fed's statement on Tuesday that it no longer sees weak growth as the greatest threat to the economy, Goldman Sachs now expects rates to rise by 0.75 of a percentage point this year. Meanwhile yesterday's Bank of England minutes suggest the Monetary Policy Committee is no longer thinking of a cut. A rise in rates similar to that of the US seems most likely, though of course we start from a higher base. The next move of the European Central Bank will presumably also be upwards, though it will want to see some greater evidence of price pressures easing. And remember that one central bank, the Swedish Riksbank, has just made the first upward move. Expect Australia and Canada to be next in line.

Lots of straws in the wind, then, of a more bracing monetary climate: what might this mean for investment?

Well, the central banks will only tighten as and when it becomes clear that the recovery is secure, but when they do they will have to compensate for their monetary laxity over the past 18 months. They have been successful in maintaining demand and supporting asset prices – I saw just yesterday that US housing starts are the highest for three years, just the sort of sector you would expect to be stimulated by cheap money. But the more successful they have been in pumping things up, the more they will want to use the upturn as an opportunity for clawing back any excess liquidity they have created.

The assumption that markets should make is that there will be no easy accommodation of inflation: yes there will be a recovery, but the squeeze on prices – and hence profits – will remain.

This leads to one of the great questions occupying fund managers: might this recovery be different in that it will benefit bonds rather than equities? If there is no danger of renewed inflation (and always the latent danger of deflation, witness Japan) maybe better to forego the potentially greater returns on equities and reap in solid interest on bonds – particularly since equities are still highly valued by historical standards.

The problem in analysing this is that every country is different. The various equity markets are at different valuations, of course, but in addition institutional investment preferences and traditions are completely different too. Compare the low weightings given to equities in German pension funds with the 70 per cent or so in the UK. Other things being equal you might expect the German percentage to rise and the UK one to fall.

As far as Britain is concerned some sort of decline is already evident. A couple of months ago the Boots pension fund caused a bit of a stir by announcing that it was switching its entire portfolio to bonds but actually the more general national shift had already begun nearly a decade ago. The peak in terms of equity allocation of pensions funds in the UK was in 1993, when it was more than 80 per cent.

Seen as a proportion of the total value of UK equities the fall is even sharper, as the chart on the left from ABN Amro shows. You could argue from this that it won't matter too much to share prices if pension funds do carry on making this switch, for they are not now that important. There was a fear that the Boots move would nudge others to follow, thereby undermining share values even more.

That does seem to be happening. But since this process had been going on for a decade the further impact is not likely to be huge. ABN Amro argues that while there are plenty of sensible reasons for funds making some shift to bonds, the cult of the equity is not dead yet. The benchmark should depend on the age of the fund: the longer the time-horizon the higher the share of equities.

Still, some further shift seems likely. If so, what are the opportunities for getting a slightly higher return, in exchange for a slightly higher risk, by investing in corporate bonds rather than government ones?

The argument here is that there is nothing much that can be done about long-term interest rates for AAA borrowers. All you can say here is that provided the central banks take this opportunity to nudge up rates, there will be little danger of a return to inflation and government long bonds should remain a decent investment.

But they will never be a very exciting one. If you can gain 2 to 3 per cent a year on top of government bonds by going for those of solid companies instead, not only do you get a higher running yield; you also have the possibility of capital appreciation if the spread narrows.

The gap between AAA government debt and Baa corporate debt is now 2.4 per cent, which is high by recent historical standards. This is the "flight to quality" effect – though the Baa is not rubbish but the debt of very decent companies.

Goldman Sachs has done some fascinating work trying to explain/predict this gap and the results are shown in the right-hand graph. The results of all computer models should be read with caution but if this one is at all right, the spread should narrow sharply in the next two years.

That would be a huge investment opportunity and one that would make intuitive sense. As confidence returns to the US company sector, confidence in its bonds should rise even if low pricing power holds back profit and divided growth. And of course once some of the impending capital reconstructions of the really dud companies are out of the way, confidence in junk bonds should seep back too.

Conclusion? Something big may well be happening. It is always very hard to see great seismic shifts that are obvious a couple of decades later but at the time are just a series of none-too-important stories that do not necessarily seem related. However, some sort of reallocation of weights between bonds and equities is already taking place and this may move quite a bit further in the coming months. This shift may not, on a long historical time horizon, turn out to be as significant, say, as the switch into equities that took place in the UK in the 1950s. But it may – and it seems already to have begun.

Comments