Oil and Gold Suffer...

Andrew Vaughan - Tue 14 Mar, 2006

"...Across the Sea of Japan, meantime, neighbouring South Korea raised interest rates again for the third time in five months in February. So while foreign investors may still be buying Japanese shares, the locals are selling. My long-term optimism for Japans recovery remains in place..."

Andrew Vaughan, on bubble watch in Dorset:

- What to make of it? The volatility that plagued global markets in the autumn has suddenly returned. These choppy conditions have shaken the faith of many commodity and energy investors.

- But the imperative of having "hard asset" exposure in your portfolio hardly needs restating for Daily Reckoning readers! And it's not only oil and gold that have suffered notable gyrations...

- Tokyo shares have also had a roller-coaster start to the year, and we've seen some surprising strength in Shanghai ‘A’ shares. Here in the UK, daily share price swings of several percentage points are commonplace, even in FTSE-100 component companies.

- In Japan, the short-term prospects for further gains in the Nikkei look to have evaporated. The Livedoor scandal and the trading bottlenecks on the Tokyo Stock Exchange were an irrelevance. What's changed is the growing sense that Prime Minister Koizumi will lose his bottle and fail to push through key reforms in the few remaining months of his office.

- Across the Sea of Japan, meantime, neighbouring South Korea raised interest rates again for the third time in five months in February. So while foreign investors may still be buying Japanese shares, the locals are selling. My long-term optimism for Japan’s recovery remains in place. Short-term, though, the Nikkei is no place to make money. But there is also a powerful new force at play in Britain's domestic markets. It could signal a serious opportunity as 2006 unfolds.

- Think this is an irrelevance to you as a private investor? You may only have a passing interest in the boring old gilts market. You might think the recent surge in gilt prices – driving the yield on 50-year index linked gilts down to around 0.5% - an irrelevance.

- But for the biggest pension institutions, the multi-billion pound investors who also happen to drive the UK equity market, the long-dated index linked gilt yield has become something of an obsession. Private investors would do well to share a little of the fund managers' fascination.

- The City's obsession with index-linked gilts affects not only their behaviour towards gilts, but also towards corporate bonds, equities, commercial property...just about any asset class you care to name! As readers of The Daily Reckoning well know, at the heart of the problem is the fact that the long-dated government bond yield is regarded as the risk-free benchmark yield against which all other investments are measured.

- And now, awkwardly, there is a bubble going on in the long-dated government bond market. It's distorting prices across the UK financial sector.

- Daily turnover in the gilt market is vast, running at about double that of the UK equity market. But in long-dated gilts - and particularly index-linked gilts - the supply is small and prices have being forced to unforeseen high levels. The new mantra for pension fund trustees, mindful of their obligations and the looming power of the pensions regulator, is quite simply to accumulate investments that directly match their long-term obligations to pensioners. This only adds to the buying pressure on long-dated index-linked gilts, however.

- Think of it as "reckless caution". If risk has to be removed from the investment equation, then the only investment that can guarantee to provide a fixed return - adjusted for inflation decades into the future - is the index-linked long-dated gilt. And that is what the fund managers must have, regardless of price.

- The Treasury issued £2.5bn of 50-year conventional gilts in mid-February, and sold £625m of 30-year index linked stock last Tuesday. There were further two long-dated index linked issues in the previous three months, raising less than £0.9bn each. Against total gilts in issue of about £355bn and average daily turnover in the gilt market of around £13bn, these new issues are insignificant. Short of the government flooding the long-dated market by issuing an ocean of new gilts, or pension regulators accepting that long-term investment must entail an element of risk-taking, the problem of soaring prices – and shrinking yields - will continue to feed on itself.

- What it means for you and me, however, is that falling yields are forcing the nation's existing pension deficits to expand, prompting the purchase of even more gilts. As the benchmark is mis-priced, then other asset classes have the potential to become mis-priced too. And next to the long-term gilt yield, yields on other relatively secure income producing asset classes are beginning to look absurdly generous.

- Prime commercial property, utility businesses and prime infrastructure assets such as ports, toll roads and airports all spring to mind. Risk-allergic pension fund trustees cannot touch them, but their frenzied activities in the gilt market are creating ‘bargains’ all around. Little surprise therefore that debt-financed mergers and acquisition activity continues apace.

- At the Zurich Club, our own holding in a commercial property agent – up some 180% in the last year alone – bears testament to buoyant activity levels in this sector. Indeed, such low long-dated interest rates have the potential to launch commercial property and other prime income-producing assets into another upward surge. Recent takeover targets, meanwhile, have included P&O Ports and BAA, the world’s largest commercial operator of airports and one of the UK’s principal commercial landlords.

- In short, the tide is coming in. For the time-being at least, many investment boats are being floated.