SUMMARY. A debate is raging as to whether the weight of government debt will eventually sink the UK economy. So far the markets support those that believe a new, albeit unexciting, stability is in place. But some adjustments to portfolios should be considered.
In last months update we concluded that while the range of possible outcomes for the UK stock market was very wide, it was encouraging that a new, higher, floor had been put under the riskiest assets, as we appeared to have side-stepped Great Depression II.
But a debate is raging amongst big name economists and columnists (from Paul Krugman to Martin Wolf, and a variety of other worthies that write to and for the FT), centred on the recent rise in gilt yields (and Treasury’s in the US). Is this a normalisation of yields, and to be applauded? Or, in sharp contrast, is it the beginning of a new ugly trend which will end in double-digit yields and inflation, the credit status of the US and UK being downgraded, a collapse in their currencies, and a new downward leg to the bear market that has (arguably) already persisted for 9 years.
The normalisation argument is easier to justify. Government bonds benefited from a dash to safety in the Autumn, pushing yields down to under 3% on 10 year gilts, as the world panicked over deflation and the prospect of Great Depression II, now they are heading towards 4%, because we have moved from an extreme outcome to something less so. This “new normal” is not a rip-roaring recovery, but rather a dull stability, which could persist for years.
It is the normalisation argument which is being bought (literally) by markets. A few days ago the UK successfully sold 40 year gilts (with yields around 4.6%), which simply couldn’t happen in times of extreme stress, when investors are drawn to the security of very short-dated gilts.
Who’s right in this debate? No one knows, of course. And both might be right – we could enjoy the new found stability for an extended period, and yet still suffer much higher inflation but not for a number of years. The arguments of the protagonists in this debate are infected by so many prior biases and one-sided stats that it is very difficult to objectively measure the possible outcomes. Moreover the historical precedents range from limited to non-existent.
Yet there should be no doubt that we are in the midst of a huge real time experiment with QE (and spiralling Government debt) at its centre, and the “new normal” is just a clambering back up on to the tightrope.
Talking of that tightrope, last month we referred to our (only half tongue-in-cheek) forecast earlier in 2009 that footsie could hit either 2000 or 6500 by end 2009. Legal and General have just updated their forecast, with 4800 the level which is implied by a sub-par recovery in 2010. But slipping off the tightrope would justify a level of either 2800 or 6500, the former based on renewed deflationary concerns or the latter on a robust recovery.
Putting to one side the more extreme possibilities for now, our guesstimate would be that the footsie needs to drift sideways and down, possibly until the results season begins in September/October, when positive news on profits could support a new leg upwards towards 5000.
Gilt yields could certainly influence the outcome for the stock market without needing to spike into double-figures. If 10 year gilt yields move into the range of 5-6%, they would become relatively more attractive than equities, at least until there is a clear profits recovery to underpin equity valuations and renewed dividend growth.
To conclude, acknowledging the range of possible outcomes (however unlikely some might seem) it is sensible to take action to reduce the impact of the more extreme possibilities, while also harnessing global potential. For example:
• In a sub par, low interest rate world, assets that can sustain decent levels of income should continue to be bought, for example high yielding equities
• High yielding equities should be bought globally, not just in the UK, to benefit from any renewed sterling weakness, and superior long term growth potential in Asia in particular
• Corporate bonds in the UK should be preferred to gilts, and global corporate bonds should be preferred to (most) global government bonds