Bonds are still no 'chance of a lifetime'

Speak to many corporate bond fund managers these days and they will be more than keen to inform you about the “chance of a lifetime” or “once in a generation” opportunity to take advantage of the fallout from the credit crunch.

There are undoubtedly some fantastic opportunities out there at the moment, but there are also plenty of risks to be aware of. Based on a basic reading of the economy, the discussion about whether the UK will see a recession or not seems somewhat redundant – we are already in one.

Under normal circumstances, the response to such a slowdown would be to stimulate activity by lowering interest rates and providing a fiscal boost from the government purse. Unfortunately, these are not normal circumstances.

Inflation – the feature responsible for the genuine “chance of a lifetime” opportunity for bond investors during the early ‘80s is featuring high on the agenda once again. While most commentators are focusing on the price of petrol or the costs of food as the source of inflation, they are failing to acknowledge the root cause of the problem which is - and always will be - the oversupply of money within the economy.

Take the UK. Broad money supply grew by 12 per cent over the course of 2007 as a whole. On its own that is not an overly worrying statistic. But when you consider that this came hot on the heels of a prolonged period of money supply such that, since the turn of the decade, supply has reached an annualised pace of 10 per cent then you have got a problem.

Money and nominal economic growth go hand in hand. Since nominal economic growth comprises a real growth component and an adjustment for inflation, in an economy capable of growing by 3 per cent at best in real terms, 10 per cent money growth is simply incompatible with a notion of “price stability” and explains why inflation is on the rise and why the Bank of England is hamstrung in its ability to administer rate cuts to the economic patient.

To understand how this happened and the consequences for the future, it is important to have a handle on how money is created in the first place.

Money is created when a bank agrees a new loan with a customer. Conversely, money is destroyed when you repay the loan, or, as is happening now, the bank has to write it off as a bad debt.

At the moment, there are plenty of debts being written off, leaving banks with insufficient equity capital. Given that a “typical” bank balance sheet may have £25 of assets supported by £1 of equity, these write-offs also have the effect of wiping out swathes of new loan capacity at the same time.

At its simplest, borrowing is, by definition, the bringing forward of future consumption and investment to the present day. With the borrowing taps turned off, it should come as no surprise that the economy has all but ground to a halt.