Anything But Gilts

This article appeared in The Spectator, issue of 21 May 2011.

Imagine for a moment that you were sitting in the aisle of St Paul’s Cathedral at the royal wedding of 1981, waiting for the mismatched bridal couple to arrive and idly speculating about the best way to save up for a wedding present for their first-born, a generation hence. The odds are that you would not have given much thought to British Government stock, or gilts, as the investment of choice.  

At the time gilts had become the pariah of the financial markets, shunned by anyone who had followed their calamitous decline in value over the postwar period. Inflation is the great enemy of bonds, and so great was the loss of faith in Government debt as a store of value in the face of the country’s continued economic incontinence that in 1981 most issued gilts were trading at 40% or less of their face value.

One infamous issue, undated 2.5% Consols, which had once provided the fictional Forsytes, and many a real life Victorian family dynasty, with their income, had fallen so far that its price at one point barely exceeded its yield, a hitherto unimaginable event.  Issued at £100, the bonds at their lowest point were trading for around £16 each. The Government was guaranteeing to pay – every year and indefinitely – annual interest payments worth more than 15% of the initial outlay.

With hindsight this turned out be one of the great bargains of the century. A combination of belated Government resolve, technological change and a flood of cheap goods from China and other emerging markets ushered in a long and sustained period of falling inflation, which in turn drive down interest rates to levels last seen in the 1950s. These trends proved just as beneficial for Government bonds as the inflationary, strike-bound, oil-oppressed conditions of the 1970s had been damaging.

Undated gilts such as the aforementioned Consols have risen more than 3.5 times in price in the thirty years since the royal wedding of 1981, producing an annualised return of more than 15% per annum, with the added benefit that the capital gains have been tax-free. The return is higher than anything gilts have ever produced in the past, and comfortably higher than shares over the same period. Gilts at their 1981 levels were a fine example of a “trade of the decade”, an investment which required just one simple decision but went on effortlessly to deliver exceptional results for ten, twenty or  even thirty years ahead.

In a world where most investors increasingly focus on much shorter term outcomes, these rare beasts are well worth looking for. For the last ten years, for example, a simple strategy of buying gold, holding gilts and avoiding shares would have produced terrific results. The gold price has risen steadily at a rate of 17% per annum over the ten years to May 2011, without experiencing a single down year. UK shares, as measured by the FTSE 100 index, have meanwhile produced just 0.2% per annum, even after taking dividends into account. (Emerging markets have done rather better). In the early 1970s, in contrast, a quite different strategy, buying oil and other commodities, and avoiding bonds of all kinds, would have made investors good returns in a generally unfriendly environment.   

The perfect “trade of the decade”, on my definition, is an investment which not only produces enduring results and is simple to execute, but can be held for years without excessive cost or monitoring.  Of course such decisions require knowledge and experience, as they tend to fly in the face of conventional wisdom, which dictates that investors protect themselves through diversification – a sensible policy for anyone who is aware of their own ignorance, but one that tends to be taken to costly extremes,  especially at big turning points in the market and economic cycle. (Diversification becomes diworsification, as the celebrated US stockpicker Peter Lynch once put it).  

By definition trades of the decade will typically involve assets which are valued anomalously – being either very cheap after a long period of poor performance (a potential buy), or very expensive after a strong bull run (an avoid). The investor needs patience and determination to buy or sell when most investors have been doing the opposite, for the paradox about good long term trading strategies is that they would not work if anybody had a good word to say for them at the outset.

Where might the trades of the next decade be found? On the assets to avoid on a ten-year view, two stand out. One is the US dollar and the other are Government bonds of over-indebted countries which , which after their spectacular run over the last 30 years, are about to enter a long period of at best poor and at worst terrible returns as inflation (and sovereign debt default in some cases) returns to centre stage. While Government bonds still have some diversification value, and would offer temporary protection if the world were to fall back into a global depression, this is not a scenario in which low maintenance decade-long returns will be made.     

On the buying side, Japanese equities are the most obvious candidate on valuation grounds, having not been as cheap as they are now since the 1970s. They meet all the criteria set out above, including the fact that there are scores of plausible reasons (poor demographics, unsustainable debt, and so on) you will hear not to own them. There will also be more profit to be had from a long cyclical upswing in the price of natural resources which began around the year 2000. That has been one of the trades of the decade just gone, but is not over yet. As the price of commodities tends to be highly volatile, the biggest risk here is being forced out of a wining long term position by confidence-sapping temporary falls (one is quite likely this year). Gold is another trade of the decade candidate from the noughties which has further to run for sure.

In Aesop’s fable, he makes a distinction between the fox, who knows many things, and the hedgehog, who knows just one great thing. The biggest investment story today is that of the global debasement of money, as governments around the world compete to trash their own currencies and put off the evil day when the consequences of the unsustainable global debt binge of the last ten years have to be faced. That in turn tells us that the trade of the current decade will have at its heart protection against inflation, and protection also against governments as they try with increasing desperation to bludgeon their way through the unappetising choices needed to bring the problem to a resolution. Anything but gilts, in fact.