Jeremy Warner's Outlook: Barclays Capital rediscovers the cult of equity

The re-establishment of "the cult of fixed income" has not yet managed entirely to snuff out the preceding wisdom of "the cult of equity", but it has come close in recent years. Briefly during the darkest days of the bear market two years ago, the yield on 10-year gilts fell below that on the FTSE 100, thus reversing a relationship which had existed since the late 1950s. The old paradigm has subsequently re-established itself, but in much weaker form, and with yields on bonds the lowest they've been for a generation, fixed-income remains very much the height of fashion. Equities, by contrast, tend these days to be seen as something nasty you'd want to wipe off your shoe.

The re-establishment of "the cult of fixed income" has not yet managed entirely to snuff out the preceding wisdom of "the cult of equity", but it has come close in recent years. Briefly during the darkest days of the bear market two years ago, the yield on 10-year gilts fell below that on the FTSE 100, thus reversing a relationship which had existed since the late 1950s. The old paradigm has subsequently re-established itself, but in much weaker form, and with yields on bonds the lowest they've been for a generation, fixed-income remains very much the height of fashion. Equities, by contrast, tend these days to be seen as something nasty you'd want to wipe off your shoe.

Many thanks, then, to Barclays Capital for reminding us in its latest annual "Equity Gilt Study" that over time shares will always outperform bonds once income is added back. With records going back more than 100 years, the Barclays Equity Gilt Study has long been the best of its type. Its observations in this, the 50th edition, seem particularly apposite as by helping to establish the cult of equity all those years ago, the study came to define the investment mores of the post war period.

The financial wheel of fortune has since turned close to full circle with an apparently wholesale exodus over the past couple of years out of equities and into bonds. Curiously, the lower the bond yield goes, the more fashionable an asset class it becomes. As Barclays' Tim Bond remarks, financial fashion seems to fluctuate inversely with prospective return.

The main conclusion to be drawn from the latest study is that this is almost certainly a mistake. To a large extent, the switch is being driven by regulators, not just here in the UK, but across Europe with the trend soon to spread into the United States. The bear market has exposed big real or potential funding deficits in life and pension funds, which in the past have tended to back their liabilities with equities. In an attempt to stop these liabilities rebounding on to the taxpayer, governments have imposed ever more stringent solvency requirements on these funds, forcing them to switch out of volatile, apparently "high risk" equities and into bonds, where there is near absolute certainty of the rate of return.

There is growing evidence to suggest that this trend is causing what the Americans sometimes refer to as a "reverse run on the bank". The more regulators require long-term investors to switch into bonds, the greater the demand for bonds, driving the yield ever lower. This in turn reduces the financing costs of government debt, so that less debt is issued, further increasing the weight of demand on supply. This is great for the Government, but it is hard to see the advantage to long-term savers.

Indeed, the idea that government bonds are riskless is a myth. The risk is inflation, which can destroy the value of bonds with hurricane force once it gathers pace. Most big defined benefit pension schemes have capped the inflation proofing of their benefit at a relatively low level, enabling them to know exactly what their future liabilities are. However, the risk of inflation destroying the value of the investment is still there. It lies with the pensioner rather than the employer. Governments may have reduced the risk of underfunding, but in so doing they have enhanced the risk of losing out to inflation, as well as making employers more reluctant to provide these benefits in the first place.

Few would think of inflation as any sort of a threat right now, but according to Barclays, the demographics of ageing is quite likely to make it one. This is because as the workforce shrinks as a proportion of the population, labour will become an increasingly scarce resource, creating wage and price inflation. At the same time, the demand for investment assets will decline, partly because of liquidation to fund retirement, and partly because there will be fewer workers competing for them as a form of saving.

The upshot is that ageing may mean higher inflation and interest rates, but deflating asset prices, the very reverse of what we've seen in the past 15 years. In these circumstances, the investment most likely to keep pace with inflation is equities. The cult of equity seems to be taking time out, but its moment will come again, and whatever the pension funds are doing, for the long-term investor it still looks the investment approach least likely to end in a nasty mass suicide. The bottom line is that you cannot have decent investment returns without risk. If you push the investor into low risk assets, you get correspondingly low rates of return, highly vulnerable to the destructive powers of inflation.

MPC split on rates

Perhaps the Prime Minister has changed his mind after the latest polls, but if the election is indeed to be as planned on 5 May, then the Bank of England's Monetary Policy Committee will have to shift the date of its monthly meeting. It would never do to announce an interest rate rise on election day. The likelihood of this happening came a step closer yesterday with the publication of minutes for the committee's last meeting showing that at least one member of the MPC, Paul Tucker, already wants a rate rise.

Two other MPC members have since been making vaguely hawkish noises, so we can assume there is now quite a head of steam building behind a further rise in rates. Only a few months ago this would have been thought most unlikely. The betting was rather on when the Bank of England would cut rates, not when it would raise them. Now the only bet worth taking is whether the next rise will come before or after the election.

That there was a fault line developing in monetary policy became obvious with publication last week of the Bank of England's quarterly Inflation Report. The report's forecasts for both inflation and growth quite plainly pointed to higher interest rates, with inflation overshooting target two years hence, and the outlook for growth a little better than it was in the November report. Yet the MPC took the view that, despite these forecasts, the risks were on the downside, this mainly because of the possibility of a marked slowdown in consumption growth.

It's still too early to be entirely certain, but the most recent evidence suggests that this downside risk is fast receding. Retail sales are still struggling, but overall consumption, supported by credit card lending, may still be reasonably robust. We may not be spending so much in the shops, but we are apparently still spending heavily on services, holidays and leisure. But the finding that will really have the MPC reaching for the whisky is the news from the CBI yesterday that there are now labour shortages developing in virtually all areas of the economy, creating upward pressure on wages across the board.

This was bound to happen eventually in an economy as close to full employment as our own. The mystery is that it has taken so long. Mervyn King, the Governor of the Bank of England mused last week on whether the old link between low unemployment and high levels of wage inflation may have been permanently broken. He may have spoken too soon.

Cadbury Schweppes

Tod Stitzer, chief executive of Cadbury Schweppes, probably wouldn't have chosen to call his strategy for the chocolate to soft drinks group "Fuel for Growth" had he known what would become of Unilever's "Path to Growth". Nor do the parallels end with the name. There are also echoes of Unilever in the bewildering array of targets Mr Stitzer asks to be judged by.

Yet this is where the similarities end, for where Unilever has so plainly failed, Mr Stitzer so far seems to be succeeding. Admittedly he's not much more than a year into the strategy, so there's plenty of time to mess up, but to judge by yesterday's numbers, there's not much to worry about. One hundred years after launching Cadbury Dairy Milk on an unsuspecting world, the company has rarely been in such fine fettle.

"We dance with elephants all the time," says Mr Stitzer. The company has had to give up some of its paternalistic principles to avoid getting trampled, but with the shares close to their all-time high, it seems a price worth paying.

jeremy.warner@independent.co.uk