View from City Road: A real worry for the stock market

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The Independent Online
Just when the stock market seemed to have rediscovered its composure, after months of discomfort at the hands of the bond markets, analysts have found something else to worry about - the reverse real yield gap.

This is not a subject that easily lends itself to attention-grabbing commentary so, dear reader, if you will, wake up, take a couple of pep pills and concentrate. The real yield gap is not to be confused with the reverse yield gap, under which equities, on average, yield less than gilts, and so called because it was not always thus. Up until the mid-1950s it was the other way round, with gilts, perceived as the safer investment, yielding less than equities.

Then along came a new age of inflation - which destroyed the notion that bonds were as gilt-edged as they pretended - and George Ross Goobey with his cult of equity. As the perception grew that equities, though riskier, were largely inflation-proofed, the yield gap went into reverse. With a few blips, that relationship has remained largely unchanged ever since. A few wild voices have argued that - with Britain now living in a low-inflation, low-growth environment - things should change again, but the markets have largely ignored them. Few yet believe the beast of inflation has been burried for good.

The real yield gap is something a bit different - the gap between the dividend yield on shares and the yield available on index-linked gilts - and what has been bothering analysts is that it has recently turned negative. The last time it did this was in the run-up to the stock market crash in 1987.

Does this mean shareholders should be rushing to cash in and head for the nearest building society? Maybe, but probably not. At worst the fact that equity yields have fallen below index- linked yields means that shares may have run slightly ahead of themselves.

Since the first index-linked gilt was launched in 1981, they have yielded on average a good 1 percentage point more than shares with the spectacular exception of 1987.

The yield on index-linked stocks gives a guaranteed rate of return no matter what happens to inflation. On the whole this has been worth more to investors than the attractions of real dividend growth on shares because of the riskiness of equity returns.

Faced with a negative gap, analysts are drawing different conclusions. The more bearish, like UBS, say that it will pull the FT-SE 100 back down to 3,000 by the end of the year.

Others, like Mark Brown at Hoare Govett, are less concerned. He says that there is, in fact, no gap if you look ahead to the expected yield on shares in a year's time - the correct way to do things - because of current strong dividend growth.

He believes the small reverse real yield gap is probably best seen as an indicator of increased optimism about corporate recovery, rather than a deluge to come. But if you don't accept that the recovery is going to last, then pile out of equities into index-linked gilts.

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