What is the most challenging task for analysts in modern investment markets?

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Aside from justifying the pay of investment bankers, a plausible candidate would surely be the difficulty of identifying in advance the emerging secular trends that will prove to be the most important influences on returns over subsequent periods of 10-20 years.

This simple sounding objective in practice is something that the professional investment community finds surprisingly hard to pull off, as Jim Grant, the noted New York bond market watcher, noted in a recent speech. Like me, Mr Grant is just about old enough to recall the historic nadir of bond prices in 1981.

In the US bond markets the date of September 30 1981 marks the day when the yield on 10-year Treasuries hit its all-time high of around 15%. Not long before, in the gilt market in the UK, the price of undated 2.5% consols briefly fell below their yield for the first and only time in two hundred years of trading.

This startling development, which hindsight was to show marked the onset of the longest and most profitable bull market in bonds that the world has seen, was the prelude to a powerful short term rally. The total return on benchmark gilts over the course of 1981 was 43% and anyone who bought bonds at the time was fated to earn a compound return that was still running at over 9% per annum more than a decade later.

Mr Grant recalls how even three years later, in 1984, few bond market experts had any inkling of the seismic change in bond returns that was unfolding around them.   He quotes the chief economist of a US broker-dealer as saying in that year that buying bonds had become “a dangerous career decision” for investment managers. “They are putting their careers on the line to go out and make an investment whose potential rewards don’t justify the risk”.

Similarly, instructed to write a feature article on the annus mirabile of 1981 in the gilts markets for my London newspaper, I could find no participant in the market who was bold enough to predict that the outlook for UK government bonds had changed decisively for the better. Most remained fixated on the dire economic data that apparently justified such extraordinary and unprecedentedly high bond yields.

Given what has happened since, it is strange to recall also that there was no such thing at the time as a sterling corporate bond market. If government bonds were still widely mistrusted, there was simply no market at all for long term sterling debt issued by companies. It was not possible to discuss the validity of current spreads between corporate and government bonds as there were no issues against which to calculate a spread. 

Even 15 years after bond prices touched their all-time lows, there were still many professional investors who refused to believe the thesis of Roger Bootle’s book, The Death of Inflation, that irresistible forces were driving down inflation and inflation expectations to levels that historically-minded investors found impossible to comprehend. The brains of most market participants were plainly not wired to contemplate a world that was so different to that which had defined all their working experience over the previous 25 years.

A good question now is whether the great bull market in bonds that began in 1981 has run its course. Could we have reached a point where all the assumptions that now drive investors’ attitudes to bonds once again have become so widely shared that a long term reversal is now in prospect? Noting that the yield on 10-year Treasuries touched an all-time low of 3.1% in June 2003, Mr Grant has no doubt.

Forty years hence, he told his audience, he was willing to bet that “we will look back at this juncture in bond market history – at the ground-hugging nominal yields, at the rising rate of inflation and at the deep-rooted complacency concerning the judgment and capacity of our central bankers – and ask ourselves a question: just why weren’t we selling the ears of the US Treasury 4 3/8s of February 2038?”

I share that view. There are other questions too. Has the credit crunch put paid also to another striking phenomenon of the last 30 years, namely the inexorable rise in importance of the financial sector as a component of US and UK equity market returns? For a wide range of reasons we seem poised to enter an era when banks will no longer aim (or be allowed) to be treated as growth stocks. A period of boring consolidation is called for, with potentially wide-ranging consequences for investor returns.





Jonathan Davis
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