Market Update 13th February

Income or outcome?

Having overcome the previous week’s dyspepsia, markets have become rather more somnolent. As if on a long haul flight, however, they are about to be awoken from their welcome doze with another tray of food. This week’s menu is dominated by the January inflation updates from both the United States and the United Kingdom. The former, in particular, has very little room for disappointment in the aftermath of the very strong employment data at the start of the month.

On the basis that there is precious little new that we can say about inflation and interest rates, and also that by now you are probably bored of our pontifications on these, this week we instead muse on the eternally thorny topics of income and the relationship between bonds and equities.

Bonds and equities can be thought of as Elizabeth Taylor and Richard Burton. Time was when accepted wisdom decreed that as equities were riskier than bonds (which essentially meant gilts), then investors should be compensated by receiving more income. The value of equities was seen to go up and down, and companies could cut their dividends in tough times. QED that they bore the greater risk. That view generally held sway from the time that we slithered from the primordial soup until the 1950s. A decade or so after the end of the Second World War inflation reversed the equation. High inflation meant an erosion of the value of bonds, in real terms, while companies were able to provide investors with better protection by raising their dividends. Quite rightly, a new order had emerged. Bonds yielded more than equities because they had the greater inflation risk.

If one excuses the occasional dalliance, the sway of this new order held until the Great Financial Crisis and the era of quantitative easing. This brought with it a new new order. Importantly, it was undeserving of the epithet ‘quite rightly’. QE, as we come to know it, created the most monstrous distortion of asset prices. Investors, generally, are not stupid. When presented with a free lunch, they tend to feast. Under QE, the Central Banks’ promises to buy bonds allowed the world and their dogs to purchase these in the markets beforehand, secure in the knowledge that no matter what price they paid, the Central Bank would pay them more. This even worked if the bonds in question were priced to provide yields of less than zero: a negative interest rate did not matter if the Banks had guaranteed to pay even more.

As we know, the process of QE drove bonds yields near to, or below, zero. Any previous relationship with equities, risk and inflation was ejected from a very high window. If anyone now wanted to receive an income from their investments (which, ultimately, is broadly everyone), then bonds had been taken out of the equation. Regardless of anyone’s propensity or capacity for risk, if you wanted an income, you had to own equities. And in particular, UK equities. Anyone who wished, reasonably enough, to take an income of 4% or so, from their portfolio was more or less compelled to own a good chunk of UK-based, dividend paying equities.

In itself, this ought not to be necessarily a bad thing. Unfortunately, we have had two extraneous events to complicate matters even further. The first was Brexit. Our vote to leave the European Union was taken very badly by most of the rest of the world. The shares of domestic British businesses were given what we may call a pasting. The second event (and events, as Macmillan taught us, are usually to be feared) was covid. Specifically, the view that the pandemic meant we, and future generations, will live our lives in physical isolation on the internet. No one was interested in dull old British businesses, what everyone wanted was the internet. We will still be arguing the rights, the wrongs and the excuse-mes of this for many a year, but British business were given another pasting. Again, those who had the very simple objective of wanting to take some income out of their investment portfolios were on the wrong side of a very painful phase of the market. And we remember that as sensible as it was to hold these boring and typically British dividend paying equities, the proportion of the portfolio needing to be invested in these was unnaturally high because QE had taken bonds off the menu of income paying assets.

It is unlikely that many will view Liz Truss’s tenure in Downing Street with great fondness. Allow me to try to argue differently. The rise in gilt (and other bond) yields should be welcomed with more than just open arms. Yes, we had the side show of some very stupidly over-leveraged pension schemes (that is tautological: over-leverage is always stupid), but we are moving back to seeing more sensibly-priced bond yields than before the GFC. Which is a very long time. Bonds, even sovereign bonds, have become a viable and valid investment for those wanting to take income from their portfolios.

And this takes us full circle to this week’s inflation updates. The 3.5% or so available from the gilt market today may seem a bit silly in the context of 10% inflation. The UK’s rate for January is expected to be slightly above, at 10.2%. But…if we give any credence to Rishi Sunak’s promise to halve inflation, or to the Bank of England’s forecast of a year end rate of 3%, and possibly below 2% in 2024, then gilts are, one might argue, already providing a positive real yield.

Jim Wood-Smith – Market Commentator and Head of Climate Transition

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