Mind the reverse yield gap
Share
The flight to quality was followed by the dash for trash but the emphasis could well shift back to quality firms with overseas earnings
Last week was a little tricky for markets. While the FTSE 100 index got off to a flying start, returning to levels
not seen since before the Lehman collapse, news that the Chinese government was to rein in the banks prompted profit-taking.
With so much riding on the populous emerging nations of the Far East leading the world economy out of recession, any negative news was bound to create alarm. But any consolidation in the domestic equity market will have some benefits.
Yield remains a concern for many investors, even though the reverse yield gap has reasserted itself.
This measure of relative value between bonds and equities has been all over the place recently. Originally a yield gap - meaning that shares returned more in income than government bonds, it swiftly moved to a reverse position as inflation eroded the value of both capital and interest from bonds.
Our experience, since the Second World War at least, suggests that well run companies should not only reward investors through rising capital values but also provide a rising income.
Indeed, the long-run measures of investment returns show that half the uplift in total return value comes from the dividend stream. So, the original contention - that equities should yield more than gilts to reflect the greater inherent risk - was overturned.
The flight to quality engendered by the financial crisis, coupled with fears of deflation, brought the yields on equities back above those on gilts.
It has taken a return in confidence, leading to a significant bounce in share prices, coupled with some profit-taking in gilts as investors lock in gains ahead of any rise in inflation, to restore a relationship that had held firm for more than half a century.
Anyway, the fact that we now have a reverse yield gap again has been put forward as an argument for considering shares cheap. I am not sure I find that easy to follow.
Surely, shares yielding more than government bonds provide a more compelling case for buying equities? But what is certainly true is that there are plenty of blue-chip companies that still yield more than gilts and thus stand out from the perceived norm.
Bill Mott has highlighted this in his latest missive to investors in the PSigma income fund. These are the companies that largely missed out in last year’s rebound in share values, with the result that equity income funds generally disappointed investors. His contention is that many of these companies remain in a position to maintain and even increase their dividend payouts, making them attractive to investors.
With the FTSE 100 index trading around 5,500, up from 3,500 around 10 months ago, finding a value argument on which to base a purchase recommendation makes good sense.
Much has been said of the dash for trash which characterised the accelerating middle section of last year’s rally. Perhaps now really is the time to return to quality. These are companies, as like as not in the oil, pharmaceutical and telecom sectors, which generally earn their profits
overseas - no bad thing given the state of the domestic economy.
It seems there may still be buying opportunities despite the market recovery.
Brian Tora (brian.tora@centaur.co.uk) is principal of the Tora Partnership
If you enjoyed this article, sign up here to receive daily email updates from Money Marketing and Follow @_moneymarketing
