There were two main stories on the front of the Financial Times on Thursday this week. The first was the big one: ‘Obama wins’; the second seemed a little more low key; ’Bonds overtake equities in pension funds’, it said.
The second was more interesting. This is the first time UK pension funds have held more bonds than equities (43% to 38%) since the 1950s. At that time, the idea that equities might be a better long-term investment than government bonds was pretty unfamiliar to most pension fund managers. Then George Ross Goobey, manager of the Imperial Tobacco pension fund, made what was to become a landmark speech at the 1956 conference of the Association of Superannuation and Pension Funds.
Here, he reminded people that it is possible to lose capital in gilts; and that, contrary to popular belief, it made sense for equities to yield less than bonds. Why? Because while the value of a bond is gradually destroyed by inflation, equity dividends should rise with inflation.
Studies going back 80 years “and including several depressions show that common stocks have increased in value at a rate which offsets the long term rate of inflation and on top of this have shown a real yield in terms of purchasing power of about 4-5%”, he said.
It sounds obvious now. However in 1956, his audience, used to a situation in which equities yielded more than gilts (the yield gap), wasn’t entirely impressed. As soon as Ross Goobey had finished, a Mr F W Goodfellow stood up to dismiss his argument. He noted that the payments on gilts are “not passed; nor are they cut; interest will continue to be paid and you can count on receiving it every half year on the due date. This may seem humdrum but it is very comforting when you need the money.”
Then he turned on equities. There was a credit squeeze under way at the time. There was every reason to expect “higher wages on the one hand, and a natural reluctance to raise prices on the other”. That was soon to mean falling margins and dividends. He was also worried about “the reintroduction of dividend limitation on a change of government”. Today’s investors have long forgotten about this, but for much of the 1960s and 70s, UK dividend payments were frozen, first voluntarily and then by law. And as for Mr Ross Goobey’s chart showing the outperformance of equities? “I would ask you not to be mesmerised by a line on a piece of paper”, said Goodfellow.
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If, like me, you are beginning to wish you had been there on the day, you can pick up the snipey tensions by reading the speech online at www.pensionsarchive.org.uk). However, in the following years there was one clear winner. The market was in a lousy place during the conference (it fell 30% July 1955 and early 1958) but on August 27 1959 the yield on 2.5% consols rose to 4.77% and that on the FTSE fell to 4.76%. The ‘reverse yield gap’ had arrived.
And, as John Littlewood pointed out in his book The Stock Market: 50 years of Capitalism at Work, “no longer could investors expect to obtain a higher yield on equity than on a government stock”. The pension funds got the message. In 1958, Manchester Corporation, with dividend yields at 7.1% and the market on price/earnings (p/e) ratio of 5.6%, started buying. Others followed. The market rose 122% between 1958 and 1960. The rest is history.
Not everyone was comfortable with the shift of course – a row raged in the pages of the now-defunct Statist magazine in the early 1960s after “distinguished chartist” A G Ellinger announced that in the idea that the stock market would keep their money safe, “the public has been sold a pup”. Dividends would soon fall again, he said, and anyone who had bought with “more vigour than discretion” would soon be “sadder and poorer”.
He was wrong, of course. The market then rose 49% from June 1962 to October 1964 and, apart from a few blips in early 1962 and 1996, the reverse yield gap stayed with us until 2008 – when QE and fear combined to force bond yields down to historically low levels.
Today, the FTSE 100 yields 3.7%. Ten-year gilts yield half that. And pension funds have backed away from the decisions of the 1960s. So what do you do? Today’s world isn’t much like that of the 1960s but the questions for investors remain the same. First, is there inflation and will there be more? I’d say yes and yes to that. And second, do you trust the government to protect the purchasing power of your money? That’s surely a no.
One of those who argued against Ellinger in the pages of the Statist was Margot Naylor (a woman writing on investment in the 1960s!). She was very clear about the effect of inflation and government behaviour on bonds in 1962: “I believe that people who entered the market in May 1961 will be better off in 1966 than those who paid £55 for war loans last year”. It was a good call. Move forward to today and, despite the fact that Mr Goodfellow’s arguments prompt all the same worries now as they did in 1956, my guess is that, as long as you have a go at picking your equities with more discretion than vigour, you can say the same for gilts and equities today.
• This article was first published in the Financial Times