Inflation could still spoil the party

Some more reflections this week on the topical issues of Labour, inflation and the state of the markets, prompted by the timely publication of PDFM's annual survey of the investment climate. PDFM is one of the Big Four firms that dominate UK pension fund management, and its Pension Fund Indicators is an authoritative guide to the long-term trends in such things as rates of return, where the big institutions are putting their money and so on.

While it does not use such lurid terms, a good sub-text for this year's offering might in fact be "Why Investors Have Never Had It So Good". Last year pension funds achieved an average return of around 11 per cent on their assets, bringing their total assets to pounds 566bn. Over the past 34 years, the rate of return for UK pension funds has averaged a remarkably consistent 12 per cent per annum. Helped by the big growth in occupational schemes, the value of their assets has risen 125-fold since 1962, and tenfold after allowing for inflation.

The last decade has been a spectacularly good one as inflation has fallen and asset prices, including shares and gilts, have soared in real terms. The compound annual rate of return achieved by pension funds in the last 10 years has been 8 per cent per annum after inflation, roughly double the long-term average, and comfortably ahead of the growth in both earnings and retail prices.

With three-quarters of all pension fund assets invested in shares, no other country has such a high equity content in its pension fund portfolios. This heavy equity weighting has paid off handsomely in the long bull market of the 1980s and early 1990s. The obvious question now is whether such returns can be sustained, and whether this overwhelming reliance on shares continues to be justified.

Fund managers themselves seem to be starting to have some second thoughts on this matter. Although the biggest trend of the last 15 years has been the big increase in overseas equity holdings (which have doubled to 23 per cent of fund assets since 1982), between 70 per cent and 100 per cent of all net new investment by pension funds in the past four years has gone into cash and index-linked gilts, rather than into stock markets.

Such caution has been quite costly in the short term, since it means that many funds have largely missed out on the latter stages of the great Wall Street boom of the last two years. But on a longer-term perspective, it looks more understandable, given the demanding levels at which both the UK and US stock markets are now valued.

As the PDFM data shows, dividend yields have fallen sharply on both sides of the Atlantic to levels not seen (apart, briefly, from just before the 1987 crash) since the 1968-1972 bull market. The same goes for price/earnings ratios. The current UK market p/e, about 18 times company earnings, is a little down from its peak of 22 in 1994, but the average p/e ratio of the past four years is still much higher than at any time in the previous 20 years (the summer of 1987 again being the one brief exception).

It is, as I suggested a few weeks ago, perfectly possible to try and justify the current high valuations in terms of the improved outlook for inflation. It is evident that the 1970s and early 1980s were exceptional for their inflationary horrors. But, as PDFM correctly points out, the relationship between equity prices and the level of inflation is not as straightforward as some people claim it to be. In particular, a lot depends on what time frame you are looking at.

Thus, while in the long run, equities do clearly exhibit a tendency to provide positive real returns and thereby act as a hedge against inflation, in the short term the effect is usually the other way round. As my [second] chart suggests, the market tends to react negatively to inflation increases. What happens in particular is that the rating of shares deteriorates.

In other words, when inflation is rising, p/e ratios tend to fall, and vice versa. PDFM compared the returns on shares, gilts and cash for years of low, medium and high inflation. This showed quite clearly that equities produced the best annual rates of return in years when inflation has been low and the worst in years when inflation has been high.

This is perfectly logical. Although big companies can usually raise their prices and report increased profits in a high inflation environment, their real rates of return on capital usually fall, justifying a lower rating. At the same time, rising inflation almost invariably brings higher interest rates with it, which helps to makes interest-bearing alternatives to shares (such as deposit accounts and Treasury bills) look more attractive.

So where does all this leave us? Well, everything comes back, as I suggested just before the election, to what happens to the inflation outlook and the time frame over which you are looking to draw a conclusion. If investors become convinced that inflation has been tamed, as Roger Bootle suggests, then equity investors need have few fears. If you share the concerns of the Bank of England and others that medium-term inflationary pressures are rising, however, then the current level of the markets has to be a worry - especially if you are primarily interested in short-term performance.

PDFM concludes that rates of return for investors must start to come down before long. So far this decade returns on both shares (12.6 per cent) and gifts (11.8 per cent) have comfortably exceeded those of the 1960s, the last time inflation was at a comparable and stable level.

Over time, the returns must come back into line, though nothing in history says when that may be. After all, PDFM said the same thing this time last year - and it didn't happen in 1996. Gordon Brown can do his bit however if he is so minded: PDFM reckons that cutting the ACT credit on dividends will cut pension funds' annual rate of return by 0.75 per cent per annum.