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Pre-1959 yield gap




Reverse yield gap is turning the clock back 50 years
By  Sunday Dec 7 2008 12:35

The gap between bond and equity yields is becoming a critical issue in financial markets.

For half a century, equities have consistently yielded less than bonds. But the reverse is now starkly true in both the US and UK. Something is badly wrong.

The obvious place to look for clues is Japan, which has had a reverse yield gap on and off for years. So do investors think the Japanese disease of deflation and economic contraction is coming to the west?

The short answer is probably yes. But, to clarify the logic, we should first consider the relationship between bond and equity yields more closely.

Until 1959, the norm was for equities to yield more than bonds in both the UK and US. This was a simple expression of what is now called the equity risk premium.

Just as in a horse race, where the odds are better on an outsider than on the favourite, it seemed obvious that risky equities should promise a higher return than safe bonds. But, from 1959 onwards - until today - the formula reversed. Why was that?

Financial theory - which, not coincidentally, had its origins in the 1950s - has an answer to that. As Professor Paul Marsh of the London Business School explains, it allows us to state that the yield gap equals the expected risk premium on equities minus the expected growth in dividends.

Before the reader's eyes glaze, let me hastily say this expresses a fairly simple concept. To arrive at the equity yield, investors notionally add a risk premium to the bond yield. But they then adjust for the fact that equity dividends grow in real terms and also tend to rise with inflation, whereas bond dividends do neither.

It follows that inflation and growth are both crucial in determining whether the yield gap is positive or negative. The higher each of them is, the more equity yields will tend to fall below bond yields.

The Japanese example supports this. Peter Eadon-Clarke of Macquarie has a chart comparing the Japanese yield gap with nominal GDP growth over the past decade. Broadly speaking, when nominal GDP is negative, the yield gap tends to be too.

The GDP figure here may be taken as a rough proxy for dividend growth. And the essential point is that it is nominal, thus including inflation. Generally, for nominal GDP to shrink, both inflation and growth must be negative. Japan is the one country to have displayed that malign combination so far.

I should add that the historic record is rather less tidy. Prof Marsh has data* showing that both dividend growth and inflation were higher in the second half of the last century than in the first.

But I calculate that, in the five years to 1959, US inflation and GDP growth were both higher than in the five years following. So why the crossover should have happened just then remains problematic.

In addition, a crucial part of Prof Marsh's equation is the equity risk premium. But, as he puts it, the premium is unobservable - that is, it can be measured only in retrospect, not at the time.

All that suggests that, when we come to the present situation, we should proceed with due caution. That said, what do we think is going on now?

In essence, the steep fall in Treasury bond yields across the developed world does indeed suggest strongly that investors fear deflation while the steep rise in equity yields suggests they fear a sustained collapse in dividends. And they are presumably also pricing in a higher risk premium for equities. So all the parts of the equation are heading the same way.

That said, the reality is slightly more complex. Today's low bond yields represent a tension between opposing forces. On the one hand, investors crave security. On the other, an enormous amount of new bond issuance is likely on both sides of the Atlantic.

And, with another part of their minds, investors do not regard bonds as all that safe. The cost of insuring UK government bonds against default has risen from eight basis points in February to 110 basis points today - still quite a modest level but not reassuring.

In fact, bond yields could prove the vulnerable part of the equation. In the bubble years, risk was ludicrously underpriced. Quite reasonably, we should now expect it to become overpriced by a similar amount.

When that eventually corrects itself, bond yields should rise. Equity yields might also fall - to the extent that investors recover their risk appetite. And indeed, fears of deflation might prove unfounded, as might the prospect of an extreme collapse in dividends.

But not just yet, I think. In the meantime, the old-style pre-1959 yield gap could become part of the landscape.

*Global Investment Returns Yearbook (Dimson, Marsh and Staunton, 2008)


Please compare with the 1958 discovery of the world's second biggest natural gas discovery, rootcause of the global crisis:

  HALLIBURTON  's master of stealth and global P3 arrogance, crime and treason, VP Dick Cheney, holds friendly nations like the Netherlands cheap: "The problem is that the good Lord didn't see fit to put oil and gas reserves where there are democratic elected regimes friendly to the interests of the United States", he said , knowing the planet's second largest natural gas reserves at that time were discovered in the Netherlands in 1959. Global parliamentary deficit due to U.S. imposed long-term oil and gas lock-in contracts provoking incorporated governance and a constituency of special interests with legal executive privileges, forged the intramural rationale -a Trojan horse- for western democratic wrongdoing and intellectual poverty. The globalization trend was effectively captured by abusive  institutionalized strategic conduct  while seizing life and privatizing democracy. Oil and greed, Iraq and Enron... it's all America and Exxon. We reject the European 'coal and steel' submission of 1963 -Gasgate- and accuse the team-of-rivals, termed Gasunie, Exxon, Shell & the Dutch/U.S. government-duopoly of global insider-trading,  industrial abusive dominance and unfair technology advantage distorting the world's markets, truth and confidence. Even lies in committee won't prosper.    Explore this firsthand tell-tale disclosure to understand how cheap-oil energy extremism shaped your life by cherry-picking information and stove-piping communication: the purest ICTerror. Cheney is a private actor, not a public servant. Jurisdictions fail because corporate abuse prevails and U.S. drag prevents responsible development and sustainable progress.







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