Outlook: Bonds heading towards unchartered waters

In the late 1950s, George Ross Goobey, then head of the Imperial Tobacco pension fund, discovered what is taken for granted these days throughout most of the world - the cult of equity. Over the long term, he rightly predicted, equities would always outperform fixed-rate government bonds because dividends could be expected to grow at least in line with the economy and in many cases a good deal faster. As investors woke up to this now obvious truism, something very strange happened - equities started to yield less than gilts, which previously had commanded a safety first premium. These days nobody would expect any different but at the time this was a seismic shift in perceptions and investment behaviour. What peculiarly became known as the reverse yield gap has ruled ever since.

This gap has typically been maintained both here and in the US at somewhere above 2 per cent. However, since the start of this decade, it has been narrowing, albeit modestly. Still, with talk of global deflation in the air and the US long bond yield touching its lowest level since the 1930s, it is worth asking how much further the gap can decline, or whether we might even get another of those seismic shifts.

A detailed answer to this question will be contained in the forthcoming annual Equity-Gilt Study from Michael Hughes at BZW. Last year's version of this always fascinating assessment of long-term trends pointed out that the inflationary background makes a huge difference to prospects for the two different types of asset.

In the intervening 12 months the advanced economies have enjoyed another excellent inflation performance. In the US inflation has now been around 2 per cent for five years. One important consideration for investors is what is causing such inflation as there is. If it reflects greater profitability as output expands, this is good for both bonds and equities. This has generally been the case so far in the economic recovery, and indeed both markets have enjoyed an excellent run. But if higher wage rises are becoming increasingly important as a cause of inflation, then even if the rate stays low, it will be bad news for equities.

As Mr Hughes puts it, for the first time in his career there is a prospect that prices will actually fall during the next leg of the business cycle. The reasons are well rehearsed - increased competition thanks to globalisation, the effect of new technology, the Asian crisis, over-cautious monetary policy. If prices do start to drop, this too would be negative for companies and for equity yields. Already we are seeing unnerving evidence of a decoupling of bond and equity markets. The bull market in bonds continues apace. In equities it has been at an end since the middle of last year, at least in the US.

This is not to say that bonds can be expected to start giving investors a higher total return, adding capital gains and reinvested gross yields, than equities. Even during the extraordinary deflation of the 1930s, this was not true, despite the dividend cuts and insolvencies of that period. Nor does it seem at all likely that the reverse yield gap will reverse again, though this has come close to happening in Japan since the Tokyo stock market crash of the early 1990s.

But taking account of other factors, like the increasing preference of pension funds for investing in bonds as the population ages and the funds mature, and the drying-up of supply as governments run cautious budget policies, the yield gap could fall to a level below anything in our recent experience.