Gilts reflect continued uncertainty

Some investors fear a double-dip recession and are ploughing money into government bonds, despite falling yields. But others argue that the British economy could yet muddle through.

Last week the uncertainty surrounding Britain’s tentative economic recovery was highlighted by the Bank of England.

Forced to write his third open letter to the government this year explaining why inflation remains over the bank’s 2% target, Mervyn King, the Bank’s governor, said he expected inflationary pressures to temper as weak demand recovery exerts itself in the figures.

He said the bank would “stand ready to expand or to reduce the extent of monetary stimulus”, suggesting that the inflation/deflation debate continues within the monetary policy committee. (article continues below)

The debate, however, is not simply academic. For investors it is key to understanding which asset classes are likely to outperform over the short- to medium-term.

At its core is the fear that austerity measures being introduced by the coalition government could push Britain’s economy back into recession. The risk is that if public sector cuts are too sharp they could exacerbate the problem of already weak consumer demand and affect corporate profits for domestically focused companies.

It could also necessitate a rise in corporation tax to compensate for the drop in government income tax revenue, providing an incentive for banks to hoard revenue rather than increase lending in the short term.

If, however, the bond market decides that the government is not doing enough to tackle the deficit it could demand a premium for holding British government debt. This would drive up yields and worsen the already onerous debt financing burden.

Under the first scenario, British equity markets are likely to suffer while government bonds would offer relative safety against a dip in demand. In the latter, the value of government debt would fall sharply as yields drive upwards.

Graham Toone, the head of investment research at AFH Wealth Management and an Adviser Fund Index (AFI) panellist, says at current prices gilts may not present a great investment opportunity.

“With CPI [Consumer Prices Index] at 3.1%, RPI [Retail Prices Index] at 4.8% and large multinational companies such as GlaxoSmithKline offering yields in excess of British 10-year bonds, it does seem a strange situation,” he says. “We understand why they’ve performed so well because of the huge uncertainty in markets, but we look for value and so our exposure to gilts is currently around nil.”

The trajectory of the yield on 10-year gilts indicates that investors continue to plough money into government debt. Over the past three years the yield has fallen from 5.08% to 3.07% at August 16, according to Financial Express. This is despite huge increases in government borrowing during the financial crisis and an outlook suggesting a tepid economic recovery at best.

With CPI, the index that the bank uses for its inflation target, running above the yield on 10-year bonds and RPI significantly above that, investors buying in at these levels would see their principal eroded by inflation in real terms.

“In the first quarter of the year we were looking to reduce our exposure to G7 government debt,” says James Davies, head of fund research at Chartwell Investment Management. “We selected strategic bond funds with a view to allowing managers to make swifter calls than we could on the direction of bond markets.”

That demand has remained so buoyant suggests that many people predict a double-dip recession is the most likely outcome of policy. In this way preserving capital becomes more important than the search for value that may not be realised. The bears, it seems, are winning out.

“If your view is that we are heading for another recession then gilts could provide a certain amount of cover,” says Davies. “But that’s not a view we share.”

For those investors who refuse to buy into the bearish analysis there is a third way in which events could play out. If the government can tread the tightrope between over-tightening and insufficient spending restraint, the economy could muddle through without falling back into recession.

In this scenario, equity markets may stay volatile but stronger companies would be provided with the opportunity to outperform their peers and give investors a return on their capital.

“There is a risk of a serious economic dip that could prove us wrong but at present we believe the country is going to muddle through,” says Toone. “You’re only going to buy gilts right now if you’re a firm believer in a double dip.”

What this third way relies on is that Britain can make progress on its austerity drive before other major economies, most notably America, start down the same path. If developed economies start cutting spending in unison it could slam the brakes on the global recovery and even throw it into reverse.

As it stands, the bond markets have responded calmly to the stated scale of the austerity package in Brit­ain. Whether this confi- dence in policymakers continues once the budget cuts start feeding through into the economy has yet to be seen.