Don't count on a happy ending for markets
Jeremy Warner On why falling long-term interest rates could be bad news for equities
Saturday 10 January 1998
Perhaps not quite yet, but the National Savings move does in its own small way neatly illustrate the seismic shift taking place throughout the developed world in investment perceptions and patterns right now.
National Savings this week cut its rates on new pensioner bonds and children's bonds by half a percentage point to 6.5 per cent and 6.25 per cent respectively. Both bonds involve a five-year lock-in. National Savings income bonds, on the other hand, which can be withdrawn on three months' notice, now pay 7 per cent.
The situation is not quite as bizarre as it might seem, since the longer- term bonds are tax-free and therefore continue to deliver a higher effective return than the shorter ones.
Even so, this is a pretty odd turn of events and no mistake. Will we soon be in a position where it is better to save short-term than long- term? Few other savings institutions yet exactly mirror the position at National Savings, but they are all beginning to drift in that direction. Actually, what National Savings is doing is driven, not by madness, but by what's happening in the capital markets. Yields on long-dated gilts are now lower than at any time since the 1960s, but short-term interest rates continue at a relatively high level.
The reasons for this are well rehearsed. The newly independent Bank of England has thought it necessary to drive up base rates so as to choke off perceived inflationary dangers. Meanwhile, long-term interest rates have been falling. This is being caused by three factors. In part it is down to faith in the Bank's ability to hold the lid on inflation. Another factor is convergence with long-term interest rates in Germany as Britain warms to the single currency.
But perhaps most important of all, Britain is mirroring what is happening throughout the developed world. In the US, the yield on the benchmark Treasury long bond is now lower than it has been at any stage since the great depression of the 1930s.
So radically do things seem to have changed that it is now possible to think in terms of falling prices during the next leg of the business cycle. Increased competition thanks to globalisation, the effect of new technology, the Asian crisis and a perhaps overly cautious monetary policy, mean that for the first time since the 1930s there is a real, if perhaps exaggerated, possibility of deflation.
This is having some abnormal consequences for investment returns. One of the big stories this week, for instance, has been the steady stream of announcements from life assurance companies of cuts in guaranteed annual bonuses. Given that both equity and bond prices had a record year last year, many policyholders are going to find this hard to understand.
Again the phenomenon is explained by lower anticipated rates of return, particularly on bonds. Returns on new investment have, in fact, been declining steadily throughout most of the 1990s, but many life companies chose to turn a blind eye to this and continued to declare quite high annual bonus rates by bolstering them from free reserves.
After the sharp gains in gilts last year, the dam can now no longer be held. For pensions business, the fall in returns on gilts has been exacerbated by the abolition of the tax credit on dividends. Annual bonuses cannot continue to be "guaranteed" at former inflated levels. Most life companies are keen to stress that lower annual bonus levels do not necessarily mean policyholders will be any less well off. Lower returns reflect lower anticipated rates of inflation, so, in real terms, policyholders ought to be unaffected.
Indeed, if inflation does sink to zero or less, as it has done already in Japan, it is possible to imagine a situation where real rates of return become higher for savers than they are now or traditionally have been - on bonds at least. As Alan Greenspan, chairman of the US Federal Reserve, pointed out in a speech last weekend, since nominal interest rates cannot fall below zero, falling prices for goods and services raise the possibility of increased real interest rates.
Since the middle of last year, there has been extreme volatility in equity markets, triggered by the crisis in the Far East and fears that this might cause a global deflation. At its worst, this might be similar in its consequences to the great depression of the 1930s. Overly alarmist stuff, perhaps. All the same, falling prices, particularly at a time of rising wage costs, would have serious implications for corporate profits.
At the very least, Western industries, are going to be hit by a flood of cheap imports from the former Tiger economies. No wonder Wall Street is no higher now than it was last August. Wall Street's bull market is already at an end, even if US equities are so far resisting a fully fledged bear market.
The bull market in bonds has none the less continued apace. Normally the two move in tandem, believing that what's good for bonds is also good for equities. Now the two are showing unnerving signs of decoupling. The effect of this has been to narrow the traditional yield gap between equities and bonds from its "normal" level of something above 2 per cent, to something below 2 per cent. Few market analysts expect it to reverse back the other way, so that "safe" bonds once more begin to yield less than "risky" equities, as they did in the 1930s, 40s and 50s. But quite a lot think the gap will continue narrowing.
There are two ways in which this could happen. Either equities could fall, or the bull market in bonds might persist while equities continue to tread water. Of the two, the former possibility looks for the time being to be the most likely. Don't count on it though. If there is no adequate policy response to the problems of the Far East and deflation becomes a reality, even on a limited scale, we might be looking at a combination of bear and bull markets in equities and bonds. Not good, not good at all.
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