Why yield is the asset class to go after in these times

By James Barty Published: July 23 2009 03:00 Last updated: July 23 2009 03:00 One of the biggest issues facing investors in the next couple of years is the likely profile for inflation and how it will affect their decisions. Some have framed the choice as one between deflation and hyper-inflation. Even if we ignore the somewhat ridiculous "hyper" element, the implications for financial assets differ widely. If we see deflation, then the obvious pick is government bonds, with equities likely to struggle and commodities still more so, while index-linked bonds are likely to be a waste of money. If we get inflation, you can largely turn the order around, although too high an inflation rate is normally not good for equities either, as interest rates tend to be high and volatile in such an outcome. Yet is this the real choice we face? The Financial Times has been full of articles arguing that inflation is a necessary outcome of quantitative easing, normally citing a probable surge in "inflationary" lending. On the other hand, the deflationists seem to think that it is either the 1930s all over again or, if not quite that bad, at least a repeat of the Japan experience with no growth and deflation. We believe there is a good chance both of these scenarios are wrong. The Japan experience was one where the authorities did too little, too late, for too long. When the Bank of Japan finally stepped up to the plate and expanded its balance sheet greatly, it managed to do so without triggering any noticeable build-up of inflationary pressures. That is a lesson for the inflationists: creation of central bank money does not lead to inflation if there is not a transmission mechanism for it. The faster reaction of the western authorities in undertaking an aggressive easing of policy, both monetary and fiscal, has probably headed off the worst of the deflationists' fears. The very low level of short rates and direct quantitative easing is providing relief for borrowers, while higher fiscal deficits are filling the hole in aggregate demand created by the slump, just as Keynes argued it should. It is unlikely, however, to prevent the delevering of balance sheets both in banks and the personal sector. That will constrain bank lending while fiscal consolidation - a course necessary to bring government finances back to stability - is likely to provide a natural offset to the very easy monetary policy stance. In such an environment, a sub-par recovery is likely. Together with large amounts of spare capacity, this probably means that inflation will remain very subdued, possibly close to zero, although outright deflation - which we would define as permanently falling prices - is also unlikely. That means monetary policy will probably need to remain loose merely to ensure that any recovery is not derailed, rather than generating excessive credit growth and inflation. Investors should therefore prepare for a prolonged period of very low short rates. We believe that means yield is the asset class to go after. Corporate bonds and equities with strong balance sheets and dividend yields would seem to be a sensible combination of assets for a conservative investor in such an environment. After all, the competition is likely to be cash yielding nothing and government bonds (including index-linked) yielding only modest returns - although in real terms, if we are right on inflation, those returns will be respectable. The performance of commodities in such an environment is more difficult to forecast, but we suspect it is unlikely to be that good in spite of all the hopes for the Brics. Our advice to investors is to put the boom or gloom alternatives back in the bin where they belong and think of assets that will perform in a slow grind back to normality. The writer is head of macro strategy at Arrowgrass Capital Partners LLP, a multi-strategy hedge fund