News that George Osborne is considering the issue of 100-year so-called Century Bonds provides a timely reminder to investors of the devastating effect that inflation can have on monetary assets and is a further signal that a longer term re-rating of the equity market may be just round the corner.
Firstly, there is the old adage that you should always do the opposite of government. When Gordon Brown decided to sell 400 tons of the UK’s gold reserves at a 20-year low between 1999 and 2002 it signalled the greatest buying opportunity for gold in a generation.
Similarly, if George Osborne attempts to convince us that a loan to the government for 100 years on a fixed coupon represents an attractive proposition, I have no doubt we will look back on this as the point at which the long bull market in gilts came to an end.
While a successful issue would undoubtedly be good news for the Treasury – unlike Gordon’s catastrophic gold sale – it will almost certainly turn out to be a very poor long-term investment for those that choose to hold it. The reason for this is inflation and history provides a useful guide to the devastating effect this can have on the wealth of holders of long-term bonds. Take War Loan, a perpetual bond issued in 1932 to pay the debts accumulated as a consequence of WW1. Those investing £100 at the time would be sitting on just £1.74 of investment in today’s money.
Predicting the exact trajectory of inflation is always difficult, but as long as the growth in money supply (think QE and the ECB’s new LTRO mechanism) continues to outstrip the growth in the economy, Sterling (together with most western currencies) will weaken and inflation will continue to be a threat.
Similarly, such is the level of government indebtedness in the UK, Europe and the US the only palatable option left for policy makers is to inflate their way out of the problem. George Osborne knows this, hence his keen interest in selling us 100-year bonds and while he will continue to talk tough on inflation, in private his view will no doubt be very different.
The flip side of the remarkable bull market in bonds is that for the first time in half a century the UK’s largest pension funds now hold less than 9% of our equity market. This compares with ownership levels that approached 45% in 1997.
Similarly, in the US, the National Association of US Investment Companies reports that $408bn was redeemed from equity mutual funds between 2007 and 2011 and a staggering $792bn was funnelled into US bond funds during the same period.
Those looking for contrarian events will have also noticed Aviva Investors’ recent announcement that it was closing four equity desks, blaming the reduced appetite for riskier assets such as equities, to concentrate on their fixed income franchise.
The truth is that in a world awash with newly-printed cash and inflation, government bonds and bank deposits are anything but riskless. Conversely for holders of equity, the corporate sector has rebuilt its balance sheet, profits are growing and dividends are rising.
The history of the last 100 years has also taught us that bull markets in equities are conceived during times of war and financial crises and are fired by elevated government expenditure, rising inflation, pent-up demand and technological innovation.
With the building blocks in place we are fast approaching the point when we believe these fund flows will reverse and while the geo-political environment remains unpredictable, it is our view that after 12 years and two savage bear markets, we have finally reached the foothills of a new secular bull market in equities.
Simon Marsh is partner at Killik & Co. For more info, go to killik.com