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Outlook: Cracks in the optimistic outlook

Yes, equities have it again by a mile. According to the latest equity/gilts study from BZW, now renamed Barclays Capital, the average real rate of return on equities over the 79 years since 1918 was nearly four-times higher than that of gilts. Even the great stock market crash of 1929 and the awful bear market of the mid 1970s failed to reverse this pattern for any more than a brief interlude of years. And as for the crash of 1987, it barely registers as a blip on the long-term chart.

The big question is whether that relationship, and more importantly the spectacular 8 per cent per annum real rate of return delivered by equities since the end of the First World War, can be expected to continue. With the Asian crisis and talk of global deflation and recession, the fear is that this 79-year-old bull market in equities may be drawing to a close. The tentative conclusion of Michael Hughes, group economic adviser to Barclays Capital and author for some years now of this invaluable piece of research into long-term investment trends, is that it is not.

His case is a compelling one. The rate of growth of dividends is higher than its long-term average and likely to stay so for some years, boosting equity returns. Meanwhile, demographic change - more over-55s saving for retirement - will boost savings and help reduce long-term gilt yields, further increasing returns. Hence the forecast in the report - several more good years for equities because of corporate profit and dividend prospects; but also an improving relative performance by gilts.

Where are the cracks in this optimistic investment outlook? For a start, there is the near-term danger of a stock market correction. Then there is the possibility the more or less constant year-on-year increase in the corporate sector's share of the economy is halted or reversed. Profitability gains in the UK and US are in part a reflection of productivity improvements, but at some point the division of these between capital and labour is highly likely to tip back in favour of the latter. At the moment there appears to be a "new paradigm" of growth and jobs without inflation and wage claims. The worry is that this virtuous circle will prove temporary.

The prospect of higher savings thanks to the age structure of the population also depends on several assumptions. For example, if the retirement age falls, there will be more pensioners spending their past savings rather than more near-pensioners saving furiously for their retirement.

On balance, however, Mr Hughes is probably right. The short-term outlook for equities may be rocky, but further out they continue to look a good bet. The underlying economic background has unquestionably changed for the better, delivering investment returns as high as the golden age of the late 1950s and early 1960s. The most important change is reduced inflation. It is too early yet to rejoice in stable prices, but governments and central banks are determined not to repeat the inflationary mistakes of the 1970s.

A second blessing for holders of gilts is the apparent conversion of governments to prudent budget policies. The chance of big deficits, subsequently inflated away, looks remote. So, although a question mark must still hang over returns to equities in the short-term, their long-term appeal looks decisive. In some respects the outlook for gilts is even better, even if the prospect of the gilt-equity yield gap flipping back to its pre- 1958 state looks remote. The world has undoubtedly changed, but not that much.