Tim Price: In a normal market, maybe. But not in this one
UK base rate squats at 0.5 per cent, its lowest level in history — or since the formation of the Bank of England in 1694, which is much the same thing. With sporadic signs of inflation and patchy evidence of recovery, plus a new broom at the Bank of England who is expected to be boldly interventionist, the financial chatterati are transfixed by the prospect of the ‘Great Rotation’. This much-anticipated shift out of UK government gilts, and bonds more generally, back into equities reflects expectations that bond prices are due for a fall because interest rates must inevitably rise, while shares are overdue for an upswing. There’s only one problem with this thesis. It’s nonsense.
Admittedly, market forecasting is now virtually impossible, courtesy of the same blanket manipulation of securities prices by central banks that is keeping the yield on government bonds so low in the first place. Given that most western nations are essentially bankrupt, the rock-bottom yield on government paper might seem perplexing to any objective investor. If governments are functionally insolvent, shouldn’t the rate they pay for their borrowing be going through the roof?
Indeed it should. The reason it isn’t is because the banking system throughout the West is also functionally insolvent, more or less, and venal banking institutions need, for reasons that governments have done a bad job explaining, to be kept afloat. So we now have the most surreal of farces playing out in the financial markets. Bankrupt banks are lending money they don’t have to bankrupt governments who are doing the best they can to keep the game going — and manipulation of interest rates plays a key role in its perpetuation.
To get a sense of the enormity of the forthcoming crisis, consider the extent of indebtedness at an international level. According to Kyle Bass, an American fund manager who has made a fortune from his detached analysis of the continuing financial debacle, total credit-market debt globally stands at roughly 340 per cent of world economic output (measured as the aggregate of the gross domestic product of all nations). Individual countries might be expected to rack up debt-to-GDP levels of 250 per cent before, during or shortly after a war; for global debt to reach this astronomical level in peacetime suggests the financial system parted company with reality some time ago.
So the short answer to why interest rates won’t go up any time soon is because western governments and the financial system can’t afford to let them. This is an existential crisis, and one being perpetuated by financial repression — not least by forcing institutions such as pension funds to buy government debt whether they want to or not.
Another reason why the ‘Great Rotation’ may remain little more than a glib soundbite is because it betrays an ignorance of how financial markets really work today. The markets are dominated by institutional players, and there are precious few institutions, aside from so-called global macro hedge funds, that can swing effortlessly between discrete asset classes. Bond fund managers buy bonds. Equity fund managers buy equities. There is no interaction between these factions. So when a giant bond fund manager like Bill Gross of Pimco says he likes the stock market, there isn’t a whole lot he can do about it. Institutional managers remain stuck in their silos, forced to invest in their chosen asset class whether they like it or not.
The cult of indexation helps to accentuate the institutional mispricing of markets. Almost all bond fund managers are obliged to own government bond markets in proportion to their size. The largest bond markets, by definition, represent the most heavily indebted nations. So the system forces fund managers to own poor quality bonds; the poorer the quality, the more they have to hold. You couldn’t make it up.
Of course, the individual investor is free to express his own opinion about the merits of stocks versus bonds. Given the proven relationship between interest rates and bond prices (if rates go up, bonds fall), and given that rates cannot go any lower, at some point bond investors are going to have a religious experience as the faecal matter finally hits the oscillating device. But as financial repression and a tsunami of monetary stimulus have already compelled many investors into the stock market, irrespective of whatever fundamental underlying value may exist there, the response of the stock market to the inevitable rise in market interest rates will also prove interesting.
My approach to squaring these circles as an investor is only to buy quality assets that offer attractive yields, and to diversify my portfolio into areas other than purely stocks and bonds. As an asset manager I nurse grave concerns about the health of both stock and bond markets. There is definitely very little value in the latter. But this anticipated ‘rotation’ presumes that markets are functioning normally. Sadly, they are not.
Ian Cowie: I bet my pension on bond trouble. So far so good
Never mind macro-economic prattle about the ‘Great Rotation’, a cliché to be avoided like the plague. When I sold all my bonds to invest 100 per cent in shares last year, I called it ‘the biggest bet of my life’. Asset allocation can contribute more than stock selection to investment returns. The ability to back these decisions with substantial sums is a rarely mentioned advantage of defined-contribution pensions over traditional final salary schemes. In my case, I switched 26 years’ savings into global equities, including 10 per cent in emerging markets.
Without wishing to spoil the fun of a ‘two views make a market’ feature like this, it’s only fair to say that I agree with Tim Price’s analysis of the economic problems facing us. Where we disagree is about the best investment strategy to cope with them. Put briefly, I believe that bonds are very expensive and shares are relatively cheap. More than two decades of falling interest rates have boosted the price most investors are willing to pay for fixed returns. Bonds are now priced for perfection. There is little margin for error or unpleasant surprise — such as an increase in base rate, which has been frozen at its historic low for almost four years.
If interest rates do rise, bond prices will fall, because the fixed yield they promise will become less valuable relative to returns available elsewhere. I do not know when that will happen but regard it as very likely in the long term over which I hope to enjoy my pension fund. Some people reckon that when the bond bubble bursts it could knock 40 per cent off today’s inflated prices. Why should you care? Because bonds are now the biggest single asset class in many people’s pension funds.
By contrast, after a dismal dozen years in which the FTSE 100 index has made no progress at all, most pension funds have reduced their exposure to equities. But many share prices represent reasonable value. The index offers an average yield of 3.5 per cent net of basic-rate tax and there are plenty of blue chips yielding more than 5 per cent net. Think Aviva, BAE, GlaxoSmithKline, National Grid and Vodafone — all of which I happen to hold in my self-invested personal pensions (Sipps).
This combination of expensive bonds and cheap shares has made a nonsense of conventional analysis which regards bonds as safe and shares as risky. For example, ten-year gilts currently yield 2.1 per cent. That’s less than the return needed to preserve the purchasing power of money against inflation. At current prices and yields, these bonds do not offer a risk-free return so much as a return-free risk. Meanwhile, shareholders are being well paid to await recovery.
Nor is there any need to be a Little Englander. Even better value equities can be found in some emerging markets, which are currently out of favour. For example, ThomsonReuters report that the price/earnings ratio in China is now 8.5, while just over six years’ earnings will buy the average Russian share. Comparable p/e ratios in Britain and America are 13.4 and 16.9.
I have been investing in emerging markets for more than 20 years and continue to do so. This is another area where I disagree with Tim’s view. While governments in the developed world may wish to rig the market, it is becoming increasingly difficult for them to do so. Once again, conventional analysis has been overtaken by events. Emerging markets are no longer necessarily more risky than developed markets because — as the credit crisis demonstrates — developed economies are burdened by excessive debts. We have been living beyond our means for decades while emerging economies have accumulated massive surpluses. Put bluntly, we have the debts; they have the savings. Guess who will call the shots in the global economy of tomorrow?
How has my big bet has played out so far? The FTSE rose by 6.4 per cent in January, its best start to the year since 1989, raising the value of my pension fund by 7.8 per cent. That may not sound like much but when applied to 26 years’ savings it created a gain equal to a year’s net salary. But this would still be a good time to emphasise that I have no pretensions to being a Mystic Meg of the markets. There are only two types of expert when it comes to stock-market prediction: those who don’t know and those who don’t know they don’t know. So, to protect a gain that appeared sooner than I expected from disappearing just as quickly, I sold 9 per cent of my shares at the end of January and now hold the proceeds in cash.
And it would also be fair to say that not everyone shared my joy when I reported this trade. Many of the anonymous comments posted on Telegraph blogs are a hoot. I wish I had a shilling for every time I have been called a ‘stockbrokers’ shill’ and accused of puffing shares. The idea that a comment column might move markets may be intended as an insult but is inadvertently so flattering as to be funny.
Perennial pessimism remains the easiest way to simulate wisdom about stock markets, which is why it is so widespread among journalists. But it has not been the way to make money this year. Even now, most commentators prefer not to suggest positive investment strategies but instead to stroke their chins and sagely warn that there might be a stock-market correction. This must be valuable advice for anyone who had not previously considered that possibility.
Share prices may fall without warning. How very true. And when they do, I plan to invest the cash profits taken in January. As things stand, I expect to buy shares, not bonds — despite the fact that the latter have beaten the former for more than 20 years — because a trend is only a trend until it stops.
Tim Price: Stocks and bonds are both risky. So don’t forget gold
I struggle with the ‘rotation’ thesis largely because it implies a binary choice for all investors, a black or white decision to be wholly in stocks or bonds to the exclusion of all else. That is overly simplistic and not a remotely accurate summation of how I invest. I am charged with managing my clients’ life savings, a job that requires respectful humility and, now more than ever, creativity and an open mind.
So there is less clear water than it might appear between Ian’s view of the markets and mine. I agree that what are often called emerging markets are far more attractive as equity destinations than those on offer from a heavily indebted West. I particularly favour sensibly valued stocks throughout Asia and in Russia, which is the cheapest major equity market (albeit for a reason) in the world. But precisely because we cannot know what the future holds at this peculiarly dismal time, I complement both bond and equity exposure with actively managed funds that offer no specific correlation to stocks or bonds, and with tangible, real assets including gold and silver. Neither stocks nor bonds offer sufficient safety on their own.
Ian Cowie is head of personal finance at Telegraph Media Group. Tim Price is Director of Investment at PFP Wealth Management.
This article first appeared in the print edition of The Spectator magazine, dated 23 February 2013