Posted by:
Andrew Bell

15 June 2010

One of the more bizarre revelations over the past week is that the Japanese Ministry of Finance has turned to sex appeal as a marketing aid for Japanese Government Bonds [JGBs, not to be confused with JCBs, which have a use]. “Women have a thing for men who own JGBs!!...right!?” is the MoF slogan –a date expired yoghurt has more charisma than this slogan but with 10 year JGBs yielding around 1.2% at least Japanese women cannot be accused of obsessing with the size of their coupons.

A variety of exhortations and ruses seems likely to be employed by governments worldwide to sell their deficit financing bonds, using key words such as “stability”, “predictability”, “responsibility” and “thou shalt not short”. Yields on the government bonds of those still rated highly enough to be viewed as “safe havens” from market volatility range between Japan’s 1.2% and the UK’s 3.5%. These rates only appear attractive if you believe we face enduring deflation or that the certainty of a close to zero real return over time (hands up those who believe the Bank of England will undershoot its 2% inflation target) is better than volatile but probably positive real returns from riskier assets such as equities. The primary rational reason for government bonds’ inclusion in investment portfolios is that they might make money if the gloomier scenarios for economic growth (and stock markets) played out, giving some legitimate diversification benefit.

It may be that the economic outlook is written in stone, with deflation and recession the punishment for the sins of having enjoyed the debt-fuelled years of plenty. In that moral world, the thrifty would enjoy proper reward for having husbanded their resources while borrowers would repent and repay their borrowings from the boom times. The problem with this analysis is that there are more borrowers than lenders and we live in a democracy, so the policy dice are loaded in favour of making life easier for those with debts (because servicing those borrowings threatens to overwhelm the prospects for economic recovery) with the counterpart being absurdly low returns for deposit accounts. The shortage of capital in the wake of the credit crunch means that money normally locked into low risk cash accounts needs to be encouraged (by low interest rates) to move up the risk curve (e.g. corporate bonds and equities) to avoid being devalued in real terms by earning less than the rate of inflation.

In trying to weigh up the relative probability of inflation and deflation, it is sensible to ask cui bono? - who benefits from each outcome? The constituency which benefits from preserving the value of cash is less numerous than those who owe, with the crucial added factor that governments, on the side of the borrowers, have the ability to influence the outcome in favour of debt forgiveness rather than preserving the real value of savings. So, betting on deflation beyond the near term appears to have fundamental strategic drawbacks.

The relative merits of equities depend partly on pricing compared with government bonds. 10 year gilts yield 3.5%, or 2.8% after basic rate tax and 1.8% after 50% tax. This yield is guaranteed not to rise so if the Bank of England simply meets its 2% inflation target the best that investors can hope for is to mark time in real terms, with the risks skewed in favour of a higher inflation policy bias that would erode the real value of gilt savings. UK Equities have a higher starting yield (3.5% after basic rate tax) which (though intermittently and not guaranteed) will if history is a guide tend to rise with economic growth, giving a rising yield with an asset base tending to rise in value with inflation. A very rapid rise in inflation would be damaging to both gilts and equities (the PE on equities would fall, leading to near term capital losses) but a prolonged period of inflation “temporarily” overshooting official targets would be corrosive for government bonds and supportive for equities, if it reflected resumed economic growth.

The debate continues to rage over how rapidly governments should try to rein in budget deficits (in order to control investors’ fears about the inflationary mouse nibbling away at the curds of bond investors’ capital). A plan to reduce budget deficits is clearly needed, since deficits are at record peacetime levels and bond investors will not want to wait to be fleeced. However, if governments reduce their spending (or raise taxes) some other part of the economy will need to compensate, if a slip back into recession is not to render efforts to reduce budget deficits self-defeating, in the absence of a strategy for sustaining economic growth. Scepticism about Europe is rooted in the perception that the heavy deficit Club-Med countries cannot offset their tightening with demand-sustaining measures (because their economies have structural weaknesses and the Euro link constrains them from devaluing or easing monetary policy), while Germany appears to view austerity as an end in itself. The likeliest way to square the circle is for the European Central Bank’s policy to become looser, which is not certain.

In the UK, there is more policy flexibility but the fiscal stance of the new government has yet to be revealed. The desire to tackle the deficit has been widely aired but the nature of any pragmatism over timing or offsetting demand support policies is opaque. The Budget on June 22^nd will need to establish fiscal credibility without disestablishing the patchy economic recovery.  Sustaining modest positive levels of growth is likely to require healthy asset markets (to moderate consumers’ desire to save more and repay debt) and incentives for companies to increase investment, despite having spare capacity – this is likely to require a mixture of fiscal incentives and a competitive pound.

The pull between relatively attractive equity valuations (compared with government bonds) and doubts over whether policy makers will correctly balance the goals of economic recovery and fiscal stability has made for nervous markets in recent weeks. This might continue (until it becomes clear whether the economic recovery has been stymied by fiscal gyrations) but with bonds having risen and equities fallen back the risk reward trade-off has shifted in favour of riskier assets.  

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