Last Updated: 20 March 2023
If you buy an index-linked (inflation-linked) UK government bond of up to eight years’ maturity and hold it to redemption you will guarantee a negative real (after inflation return).
Source: Barclays Capital
If you buy longer-dated linkers you will pick up a paltry 0.5% per annum real return, barely enough to cover the risk of buying default insurance on the issuer, the UK government. Plus, of course, you only receive that return if you hold the relevant bond to maturity. In the interim, you face potentially large losses if real yields rise towards their long-term average of 2-3%.
By any standards UK index-linked bonds (and their conventional equivalents, on which interest rates have just fallen to their lowest level for a generation) now earn the 1970s sobriquet.
The policy of financial repression that sub-inflation yields on government debt represent is a highly risky one. In penalising savers, governments also prevent the efficient allocation of capital and destabilise their own currencies, in turn threatening countermeasures from other governments, including possible capital controls.
It was quite amazing to witness US Treasury Secretary Geithner state this week that “no country can devalue its way to prosperity” while the US, mimicked by the UK, is seeking to achieve precisely this. Watch what they do, not what they say.
Economist Andrew Smithers today pointed out the addiction to bubbles that underlies current US policy. He also highlights elegantly the inherent contradiction that quantitative easing embodies. “The Federal Reserve is seeking to lower the value of bonds, by increasing inflation. Its method is to raise the price of bonds by purchases. As a difference between price and value is the definition of a bubble, it is clearly seeking to create another bubble and may have done so already,” Smithers notes.
Safe assets in the current environment are hard to identify. Bonds, either inflation-linked or fixed-rate, offer a likely negative return at current yields (barring a deflationary collapse). It’s easy to see why higher-yielding equities are going up, but does this asset class offer any long-term value either? Equities (taking the S&P 500 as a proxy) now yield 25% less than at the 1929, 1972 and 1987 market peaks, points out John Hussman. As for the renewed fad for emerging markets and many commodities, this now seems a pure momentum trade, vulnerable to reversal at any time.
A healthy cash weighting therefore seems appropriate at current elevated market levels, which are buoyed by investor faith in further government intervention, as well as in the success of the measures announced to date. It’s hard to imagine that there won’t be buying opportunities at much better levels over the coming year or two in pretty much every asset class.