Post-crisis monetary policy has created an era of return-free risk
Central bankers, while all is not yet told, have failed to stimulate the global economy in real terms since the financial crisis. Meanwhile, government bonds now look so expensive as to be un-investable - and quality stocks have moved into dangerous bubble territory.
An example of the brewing problem in gilts is the UK government's Treasury 4% 2060, for which the current price offers a 1.27% yield over the remaining 41 years of its life. Assuming that the government hits its 2% inflation target during this period, investors will see the inflation-adjusted value of their investment in the bond eroded by 0.73% a year, guaranteeing a steady erosion of spending power.
But it could be worse - there must be at least a chance that inflation will be higher than 2% in the next 40 years. Some may remember the 1970s, when inflation hit 20%. These low-return fixed-interest investments would be defenceless in such conditions, leading to price implosion.
One third of the world's pool of government stock now offers a negative return - a guarantee that the investor who buys them will lose money. Captive investors such as banks, insurance companies and pension funds are compelled to accept these returns, but it is hard to see how anyone who has a choice in the matter would be tempted.
After the inflationary decade of the ‘70s, UK gilts paid their holders around 15% per annum, one of the highest yields in history. It has taken four decades for yields to drop to their current rates around zero.
At what point in this journey from very cheap to very expensive did gilt yields pass through their ‘normal' range? If a ‘normal' rate of inflation is 2%, then a gilt might be expected to give its holders the rate of inflation plus a margin of profit, so a ‘normal' return from gilts might be in the range 2.5-3.5% per annum. For Treasury 4% 2060 to yield 3%, its price would have to fall by 36%. However, most commentators expect the 40-year bull market in bonds to continue, and for bond yields to continue falling as their prices rise.
If a rate of 2% inflation, the target set by all central banks, is normal, it's reasonable to expect government bonds to pay 3% a year. In this case, we should expect high quality company bonds to pay 4% a year, because even the best companies can't be as solid as governments and we need a margin of safety. If that's so, then what should the rate of dividend payments be?
We should expect the safest companies like Unilever to pay less than others, to reflect their quality, and the riskier companies to pay more, to offset the added risk of not being paid. Over long periods, dividend payments have grown. Perhaps it would be reasonable, in the aggregate, for investors to accept a dividend yield across the market of 4%, accepting that the prospect of payments rising over long periods was equally balanced by the prospect of things going wrong. If that were the case, then the yield ratio would be 4% divided by 4%, in other words, one.
Over time, the yield ratio has moved a long way. At the end of the second world war, shares were seen as risky. Investors demanded a high rate of dividend income to tempt them away from the safety of bonds. The yield ratio was a low number back then, around 0.5 - shares paying twice as much as bonds. Then ‘the cult of the equity' took hold. Shares became more and more expensive, to a point at the end of the 1990s when investors had become so convinced of the attractions of the equity market that they would happily buy shares paying dividends on average less than half of what government stock paid.
The yield ratio at that time was 2.25. A sum that would buy you £9 of government-backed income would only pay £4 in dividends, compared to £18 in the 1940s - but that was acceptable, because dividend payments went up and share prices would go up too, as they had been doing for several decades, whereas gilt yields and prices did neither.
For the last 20 years, things have moved back in the opposite direction, to the point where the relationship appears to have broken down altogether. Today, the FTSE All-Share Index of the UK's 600 largest companies is showing a dividend yield of just above 4%, four times the yield on a 15-year gilt.
In two decades, shares have gone from paying less than half as much as gilts, to paying over four times as much. Who wants to be paid an income that's much higher than cash with the prospect of that income rising over time? The answer appears to be - no one! It seems that we have become so scared of the future that we can only envisage one outcome - things will get worse, and then even worse. Dividends will be cut and cut again, and finally disappear altogether. This is what the valuation of the market is telling us today.
Tony Yarrow, co-manager of the TB Wise Multi-Asset Income Fund
