This year, the price of the 10-year gilt (Treasury 4.5% 2032) fell by 25% and that of the 30-year gilt (Treasury 3.75% 2052) by 50%. Anyone who thought they could hedge inflation with indexed gilts got a shock: the price of the FTSE Actuaries UK Index Linked Gilts Over 15 Years Index fell 60%. At the start of the year, investors were massively overpaying for inflation “protection”.
Investment crashes are normally associated with high-risk stocks (tech stocks in 2000-2003, financials in 2008 and the Nasdaq this year), but not with government bonds, which are supposed to suit widows and orphans. What also characterizes this crash is that everyone predicted it: commentators, experts, strategists and asset allocators. As a result, no sane investor holds gilts for the long term – neither direct investors nor funds managed by wealth managers, financial advisers or defined contribution pension plans. So who pushed the price of gilts into ridiculously overvalued territory?
Quantitative easing by the Bank of England was an important factor. In its desperation to inject liquidity into the system (and thus cause the inflation we are currently seeing), the Bank was not concerned with the price it was paying, so the vendors took it to the cleaners. The other big contributors were pension plans using a strategy known as liability-driven investing (LDI). They fooled themselves into thinking they matched the long-term liabilities of defined benefit pension plans rather than just speculating.
Today the Bank of England, the Treasury, the Chancellor and the Financial Times are in a panic. What needs to be done to drive gilt yields down again, save LDI programs and the Bank’s reputation? The Institute for Fiscal Studies thinks the government will need to announce a £60billion budget crunch, meaning deep spending cuts, to convince investors.
Better control of public spending may be needed to improve the productivity of the UK economy, but a rush to cut would reduce spending in the wrong areas, such as investment. This would not encourage investors to view ten-year gilts yielding 4.5% as good value. Nothing would. Gilts now fetch more than US Treasuries, as they should, given the strong dollar, lower US inflation, US self-sufficiency in oil, the status of the dollar in as a global reserve currency and favorable political prospects. But the current margin of 0.6% is not enough.
Investors are always reluctant to return to the scene of a crash. Gilts will have to look unmistakably cheap to attract those who have been avoiding them for years. This means returns not only above current inflation, but with a margin that takes into account the future. With inflation still hovering around 10%, we are still far from that point. Even if inflation declines, investors will remain skeptical about the long term; this government will have to buy votes with tax cuts and spending. Everyone now expects a Labor victory in 2024; Labor governments are better known for their taxes and spending than for their frugality.
Treasury may be wrong
The good news is that the highly regarded Center for Economics and Business Research (CEBR) recently released a report indicating that the government’s budget balance will move to a slight surplus in three years. By implication, he denied the Treasury’s forecast, pointing out that freezing tax breaks for four years will significantly boost revenue. He said that with prices falling rapidly, the cost of the energy price cap could be zero – a forecast made before the cap was reduced from two years to six months.
If true, this would ease the pressure on gilt yields relative to US Treasuries. If the Bank of England raises interest rates more aggressively, that could also help, but money markets have stopped paying attention to the Monetary Policy Committee. Market rates are well above those indicated by the Bank of England, so a change in course may not impress the gilt market.
Without a sustained decline in US Treasury yields, there is little hope of lower gilt yields. A range of 4% to 5% is likely to persist. This is very bad news for LDI programs, whose sponsors, promoters and managers may be considering fleeing to a country with which Britain does not have an extradition treaty, such as Russia, the Iran or Venezuela.
Equity markets have struggled in 2022 but a return of -7% for the FTSE All-Share index and -8% for the MSCI World index hardly matches the fall in bonds. Equity markets are certainly influenced by bond markets and are unlikely to rally until global bond markets stabilize. However, equity investors never believed that the bond market was rational. If they had, the markets would have gone much higher. The US Federal Reserve’s valuation model, which compares earnings yields to bond yields, would have suggested a peak US market valuation of more than 100 times earnings. With ten-year yields at 4%, it indicates a price-earnings ratio of 25; yet, according to analyst Ed Yardeni, the forward multiple is only 15.
JPMorgan estimates the forward earnings multiple of the FTSE100 index to be just nine, with 70% of earnings coming from overseas and thus benefiting from a weaker British pound. The yield of the FTSE 100 index is 4.15%, but dividends can be expected to rise faster than the rate of inflation over the medium to long term.
It would take a big drop in corporate earnings or another big jump in government bond yields to undermine equity valuations, and these developments should be viewed as more than temporary. Bond markets may now be reasonably priced, but stock markets offer much better value.
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