Outlook: Yield gap carries ominous message

IT'S A long while ago, and not many people remember it, but there was a time when shares paid more on your capital than gilts. It started in the Great Depression of the 1930s, when companies were slashing their dividends and going bust all over the shop. Since the corporate sector was so unreliable, it was considered reasonable that shares should yield more than gilts.

Then in the 1950s, George Ross Goobey, head of the Imperial Tobacco pension fund, began to argue that since the economy was growing, and the corporate sector with it, dividends and share prices would also grow with it. Shares were therefore intrinsically worth a lot more than bonds, he argued. The "cult of equity" was born and in 1958, shares began on average to yield less than gilts for the first time since the crash of 1929. What subsequently became known as the "reverse yield gap" has ruled ever since.

Now we seem to be swinging back the other way again. The old pre-1958 relationship between gilts and shares has not quite re established itself yet, but we are beginning to get close. In the last year alone, the yield gap has shrunk from 3.4 per cent to 1.8 per cent, or very nearly halved. Taking into account share buybacks, then the gap has declined to virtually nil once more.

Traditionally, bonds and equities have moved in tandem. Not any longer. Equities go down when bonds are going up, and visa versa. This is a shift in the investment landscape of truly seismic proportions. What it tells you is that there is going to be a recession, that companies are going to go bust, earnings are going to fall, and dividends will be slashed. It also tells us that this is going to be a bad recession, possibly a really bad one.

The markets may be wrong about this, and there are still some good reasons for thinking they will be. But for the relationship between bonds and equities to change to this degree is probably more than just a brief aberration. It requires a shift in psychology and sentiment that cannot help but have a profound effect on the real economy. In this sense, the markets are determining as much as anticipating the future. Alan Greenspan belatedly recognised this with his emergency interest rate cut last week. Unfortunately, he may have left it too late.

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