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An annual comparison of returns from Gilts and Equities, published this week, claims that inflation is set to break out again. The argument is that central banks want inflation so must eventually get their way. This argument never once mentions debt service costs and completely fails to consider the corrosive effect of high real interest rates on Western economies. It's a nice story if you want to believe it. Expect it to go the way of many other nice stories from the economic establishment - remember devaluation causing inflation? Or the New Economy? Or how falling interest rates would be good for "real" assets like shares and property? When will they learn that people cannot go on borrowing more and more for ever?
There are some other details of concern. It is suggested you put 10% of your portfolio in commodities, based on an argument that commodity prices are buoyant and higher yields tend to carry forward. The argument omits to mention that the recent stimulus to commodities has largely been from China, which means that commodity prices are vulnerable to a boom and bust cycle. We also believe that the statistics are just year on year (31st December) changes, thereby ignoring the effect of higher yields on Gilts bought some years ago: note the difference to the commodity argument.
Meanwhile, according to a newspaper pundit this week, the bull market in equities is alive and well: "This time it's different" is really true!
Seven arguments were laid out for this. None of the arguments set forth mentioned cost of debt service, which is already starting to embarass mortgage borrowers in the South East of England. None mentioned demographic changes such as the ageing population and its likely effect on pension funds. Four of the seven arguments are short term factors that are already changing or likely to change soon, namely a falling dollar, expensive war, rising oil price, and profligate US Government.
If you can manage to cast your mind back to 1999, you will see the similarity. Pundits then were extolling the technology boom and promising that, in markets at least, the good times would roll for ever. A book was published with the title "Dow 36,000". Need we say more?
We thank the said study and pundit for providing an excellent sell signal in equities and buy signal in Gilts - for those who understand how to read opinion contrarily.
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© Kauders Portfolio Management 2004