View from City Road: Gilts lose their edge with low inflation

Welcome to the brave new world of low inflation, the full implications of which are only beginning to be gauged. The lowering of inflationary expectations has been largely responsible for the prolonged rallies in both bonds and equities over the past year, but it is reaching hitherto unsuspected parts. One of the more interesting findings in this year's annual, fact- packed BZW Equity-Gilt Study is that the average real return at 3.3 per cent from holding index- linked gilt-edged stock, since their launch in December 1982, has been less than the returns on not only shares but also bonds and, surprisingly, cash. Inflation-proofing? Who needs it.

The appetite for index-linked gilts was at its height when the stock was first issued, and memories of the great unexpected leaps in inflation in the wake of the two Seventies oil shocks were still fresh. In an environment of inflation-induced expropriation of bondholders' capital, index-linked gilts looked too good to be true.

Indeed, some analysts predicted that they would bankrupt the Government. However, the downward trend in inflation and periods of persistently high real interest rates made index-linked a cheap form of funding for the Government. This was one financial decision that Nigel Lawson, who was the Treasury junior minister whose enthusiasm for index-linked gilts ensured that they were launched, got right.

From the investor's point of view, index-linked have proved a dog. It has been far better, in terms of actual real returns and without taking account of any extra risk involved, to invest in shares over the same period. The rolling 10-year average real return on equities - 10 per cent last year - has been twice that of cash and compares with a return of 7.5 per cent on conventional gilts.

It may be that some future government will let the money taps open again, surprising another generation of bondholders with an unexpected burst of price rises. But there are far more powerful and better-understood pressures working against such an outcome today than there were in the Seventies, not least of these the sudden retribution of the foreign exchange markets.

Globalisation has proceeded apace. It is surely not an accident that governments have been competing in their promises to keep inflation low, and even to give their central banks independent responsibility for stable prices.