Economics: Jitters on inflation caused the wobble
Sunday 27 February 1994
This is quite plausible, given the sharp fall in gilt prices. Fifteen-year gilts are down 7.2 per cent from their high on 31 December, which in turn helped to knock the FT-SE 100 share index down 7.6 per cent from its 2 February high.
The real question is whether this is a temporary setback, or whether the forces that have impelled both bonds and equities over the last year are now going into reverse. Have we just experienced the first leg of a 1987-style or 1929-style crash?
We have to start with the story of the bull market in shares and bonds. Interest rates were driven down to particularly low levels in the United States - just over 3 per cent - by the need to save the banks from bad debts and encourage consumers to spend. Those low interest rates drove savings in search of higher yields elsewhere.
Some of the cash happily poured into bonds that pay fixed interest for long periods. These fixed rates became more attractive as inflation and variable short- term rates fell, so that bonds leapt to new highs. This depressed the yield - the interest payment as a percentage of the market value - to 30-year lows. The flow of cash also boosted shares.
In short, one of the key underlying forces behind the bull market in bonds and shares was low inflation. If inflation is now edging up, short-term interest rates will normally also edge upwards.
Bonds will fall both because cash deposits become more attractive again, and because inflation erodes the value of the fixed interest payment. With bond yields rising as prices fall, share prices will have to rely on increases in companies' earnings to spur them. They will no longer be able to rely on the unattractiveness of alternatives.
But the evidence for any upwards pressure on inflation is slight. Alan Greenspan's quarter point interest rate rise in the US was an attempt to forestall inflationary pressures rather than to respond to them. At 2.5 per cent, US inflation is still low. And it has been remarkably stable, averaging 3 per cent in both 1992 and 1993.
True, inflation lags a long way behind other factors. There is a continuing search for reliable early-warning indicators, and some of these are now beginning to turn upwards in the US. The surprisingly high US growth rate has pushed up capacity use. Although oil prices are still weak and are likely to remain so, other commodity prices have been edging up from the trough in 1992.
But it is far too early to suppose that Mr Greenspan has lost the battle to contain inflation. Usually, the Fed waits until there are clear signs of rising inflation before tightening its monetary policy. The fact that Mr Greenspan is trying a different strategy is arguably a bull point for both bonds and equities.
For UK and other European investors, it is also odd to suppose that non-US markets will inevitably mirror Wall Street. Britain is still a considerable way behind the US in terms of the business cycle. Our national output began to revive in 1992, a year after the US. The rest of Europe is further behind still.
Indeed, Britain's low inflation scenario looks even more robust today than it did at the end of the year when bonds peaked. The upturn in world commodity prices is weak by the standards of past cycles; factory-gate prices continue to surprise by their moderation; and retail inflation has consistently proved to be better than most people in the City or others expected. The only question mark is about the labour market.
In these circumstances, my betting is that the inflation optimists will get the better of the argument for another year. The Bank of England has not been alone in making pessimistic inflation projections. Most forecasters have overestimated inflation for two years, as the graphs show.
Roger Bootle of Midland Montagu and Tim Congdon of Lombard Street Research have been an exception: they haveboth called inflation and interest rates better than most over the recession, and they are still firmly in the low inflation camp.
Mr Bootle is predicting that inflation in the fourth quarter will actually fall from the present 2.5 per cent to 1.7 per cent. Mr Congdon predicts 1.8 per cent. If you look at the underlying measure, excluding mortgage payments, their respective forecasts are for a fall from 2.8 per cent to 2.2 per cent and 1.7 per cent.
There is even evidence from the markets themselves that they do not believe that inflation is picking up: index-linked gilts that protect capital value against inflation have fallen by more than conventionals since the end of the year. Overall, gilts have probably fallen to levels where long-term investors will want to buy.
So what has driven the market down? A clue is that UK bonds have followed Wall Street's lead even though the news in both places was quite different. It seems likely that the US interest rate rise increased the costs of finance for highly-borrowed speculators, who had been betting on rising bonds and a rising dollar. They were forced to sell, pushing prices down quickly.
If this is right, and the bond market rally gently resumes, where does this leave equities? Shares are inherently volatile and we may be in for a bumpy ride. Some of the traditional ways of valuing the market still look very high: for example, the price / earnings ratio is in the same territory as the peaks in 1969, 1972 and 1987.
But there are big differences between then and now. The upturn was well advanced in all those years, and bond yields were relatively high. We can now look forward to many years of profits growth, and bond yields are low. Low inflation means low interest rates and bond yields, which means high share prices relative to earnings because of the alternatives.
Nor does that other stalwart valuation measure - the yield ratio - help us much. With long gilt yields at 7.2 per cent and the dividend yield at 3.45 per cent, the yield ratio is still low by comparison with the seventies and eighties. It might suggest that bond yields must rise (ie bond prices fall) and dividend yields fall (ie shares rise). But low inflation also changes the relationship between bond and dividend yields.
One of the key differences between shares and gilts is that share prices tend to rise in line with the economy, capturing both inflation and real growth. By contrast, the redemption value of a normal gilt does not grow in line with inflation or economic growth. So the yield on gilts has to contain a payment for inflation, whereas the dividend yield does not.
As inflation is squeezed out of the system, gilt yields ought to fall more than dividend yields. In the stable or falling price world of 1918 to 1938, the gilt yield was 4.1 per cent and the dividend yield was 5.5 per cent, giving a yield ratio of 0.77. This yield ratio thus tells us more about inflation than about the valuation of shares.
It is more sensible to compare the dividend yield with the yield on index-linked government stocks, because their inflation-proofing the value of their capital is analogous to share prices. Mark Brown of Hoare Govett points out that we do not have a lot of history of this relationship, since index-linked were only launched in 1981. But the dividend yield since the late Eighties has hovered about half a percentage point above the index- linked yield.
At present, the dividend yield exceeds the index-linked yield by only some 0.15 points, implying that index-linked should rally or shares should fall. If all the correction came about through falling equities, shares could tumble by nearly 10 per cent.
A bond price rally may be more likely, since I suspect that much of the recent sell-off was an after-effect of bull market speculation. So share prices may wobble but the long-term investor should not panic. They are not about to fall off a shelf.
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