Income-generating assets have been pushed to very high valuations – the higher the certainty of the income the higher the price: gilts, corporate bonds, London property, high-yield equities – are all at or fast approaching generationally high relative valuations.
The price volatility of non-income-producing assets is also high as highly liquid investors with a negative cost of financing (after accounting for inflation) pursue inflation-beating returns.
So where does this leave the bond versus equity debate, and what advice should we give to investors?
The case against bonds is well versed. With interest rates forecast to rise, bonds will fall and should therefore be avoided. Similarly the case for equities as a protection against inflation is the general view.
If inflation is coming, buy equities not bonds. The principles in both these statements are correct, but the resulting advice looks dangerous.
With the S&P 500 index, the main barometer for global equities, up 150 per cent in five years, should you put all your money in equities? History would suggest this might be a pretty dumb move.
It remains extremely difficult to forecast if and when inflation will start to rise, when interest rates might rise, what will happen to corporate profits, investor risk appetite, and whether the five-year bull market in equities can continue without a major market correction at some point soon.
We have to face up to the fact that with equities we simply do not know. We do not know in the short term whether it will be a positive or negative return, and we do not know in the long term what the return will be.
Thirteen years on since the FTSE 100 first passed 6,900, the index has still to pass this high water mark. How long is long term? Where is the inflation-plus-6 per cent “risk premium” return espoused by modern portfolio theory for those 1999 investors? Are we at another 1999-type point?
So if you do not want to forecast and want to offer some degree of certainty in the returns you provide your investors then you have to come back to the bond markets. Only with bonds with fixed maturity dates and fixed coupons can one predict what returns will be over a given time-frame.
We might not like all of the returns on offer when we look at bond returns, but we must realise this is now the price for certainty. The 1999 investor who bought a 15-year gilt paying 5 per cent probably did not much like the return either, when tech stocks were doubling every year and equity markets generally had doubled in the past five years. But with hindsight they now have exactly the expected 75 per cent return in 15 years, and will have had a pretty smooth ride along the way.
The equity investor will probably be amazed to be worse off than the bond investor with just their dividends to console them and a return of around 50 per cent over 15 years. That is, of course, if they held their nerve and did not sell out in one of the last two 40 per cent-plus bear markets. The ride along the way has been horrendous.