The growing disequilibrium between what bonds are implying through near-zero long-run interest rates and what equities are pricing in my view requires significant thought and attention, particularly for people saving for their pensions. I recently came across the letters of a prominent pension fund manager of the 50s and 60s, the last time such a large disequilibrium existed.
In 1947 George Ross Goobey was appointed fund manager of Imperial Tobacco’s pension fund at a time when pension funds generally had very little (or zero) allocation to equities. Policy dictated investment in conservative, stable fixed interest streams to guarantee a specific level of income in retirement.
Mr Goobey made one simple observation which established him as one of the most successful British fund managers of his time and synonymous with the development of modern investment practice. The observation was that equities were yielding significantly more than bonds – and it is likely that equity earnings will grow over time (enhancing the spending power of those who own these equities). He also argued that diversification could minimise stock-specific risk such that the true risk of permanent capital loss was significantly lower than one may initially presume.
He wrote to the trustees of the pension plan outlining these views:
Source: Pension fund archive:
Point 3 in my view is the most important – “with the present and continuing inflationary tendencies ordinary shares are (with the exception of property) the only means of securing any additional income arising out of the depreciation in the purchasing power of the pound”. This is important because modest inflation may not be something we think about day-to-day, but over a lifetime of saving it can erode purchasing power materially.
George Ross Goobey’s view at the time was highly contrarian but others came to realise this inflationary protection, and gradually the “yield gap1” closed to the point where equity dividend yields traded sustainably lower over much of the next 50 years . . . until 2009. The chart shows that the spread of the dividend yield vs the gilt yield is now even wider than it was in 1947 and is at its widest point since the 1940s.
While this situation has persisted for a number of years, it is the acceleration of this trend which is most interesting – the market is now not just pricing lower for longer, it’s pricing lower for ever and this shift has happened really quite quickly.
So is the current regime different to the one George Ross Goobey was presented with? In some ways yes – the populations of many countries are ageing and productivity growth appears to be slowing, at least over the recent past. Final salary pension schemes are also maturing, making it more suitable for shorter duration fixed income instruments to match these liabilities. Nevertheless, younger investors have an increasingly difficult choice in how to save for retirement, particularly if one views a modest inflationary environment as likely over the long run.
As an equity analyst I can observe businesses which can reasonably consistently pass inflationary tendencies to customers and trade at valuations which imply long-run returns well in excess of long-duration fixed interest instruments. A 10-year gilt for example currently yields around 0.6% while it is fairly easy to find a range of equities with dividend yields of 3% to 4%, and earnings yields significantly higher. Should I worry about the volatility of this return if my time horizon is long term? Mr Goobey would argue not.
My colleagues on the multi-asset team blogged recently on this issue from an allocation perspective, providing suggestions as to why some investors may nevertheless choose to buy negative yielding bonds. There are clearly implications from an equity portfolio perspective as well and we have to be aware of the implications of current asset pricing on the businesses we buy for the long run, even if we do not believe we can forecast the near-term direction of inflation and interest rates.
The current situation certainly appears to be highly abnormal and worthy of significant thought. Many bond holders will see the real value of their capital fall should an inflationary environment persist. Many areas of the economy will become less tolerant to increases in interest rates to even modest levels (mortgage borrowers for example). Corporates may increasingly be incentivised to raise debt levels as borrowing costs become de-minimis.
We cannot anticipate how long this situation will persist but I am sure it will fill many financial text books in decades to come.
George Ross Goobey died in March 1999, but a number of his notes have been uploaded to the pensions-archive and are well worth a read.
1 The “yield gap” was used to describe the difference in yields between high-grade bonds and equities which subsequently changed to the “reverse yield gap.”
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.