Updated: May 18, 2022
I have a proposal for the British government. It’s not complicated: sell vast quantities of 50-year debt and buy vast quantities of UK equities.
"It would make sense to invest any amount to level a hill for the resulting saving in transportation costs"
In late July, the Treasury sold £2.5 billion of debt for £5.1 billion. During the lifetime of the bond it will have to pay a total of £0.2 billion in interest but this isn’t much in the grand scheme of things. Let’s say the Treasury sensibly puts this to one side and is left with £4.9 billion. Surely it can find something to do with this over the fifty years. If it can make a return on investment of at least -1.4%, then it will have the funds to repay the £2.5 billion par value.
You may have realised that I am referring to the most recent tranche of the 0.125% 2065 inflation linked Gilt that was sold on 26 July for 201.335% of par. In other words, the aforementioned return of -1.4% required to pay back the bond at maturity is a real return. You could just as easily use a nominal bond and a nominal required return. However, using the inflation linked Gilt makes it easier to understand the point at hand, namely that current yields imply the government cannot make a real return on investment of even -1.4%. (At this point I am reminded of economist Paul Samuelson’s famous remark that at a permanently zero or sub-zero real interest rate it would make sense to invest any amount to level a hill for the resulting saving in transportation costs.)
Back to my proposal: surely a basket of UK equities will return more than -1.4% per annum over the next fifty years?
They are already yielding 4.1%, so you’d need corporate earnings - and thus dividends - to fall 5.5% per annum in real terms over the long term for total annual real returns to equate to -1.4% (note: this derives from a mathematical truism that says that total return is equal to the dividend yield plus the growth in dividends, otherwise known as the Gordon growth formula). Even if we say that dividends are currently twice the sustainable level, and start with a 2% yield, we’d still be left needing earnings growth of just -3.4% per annum.
Now, earnings and dividend growth over time tend to be around two percentage points per annum less than GDP growth (note: this is because listed companies are generally the larger ones and thus have less propensity to grow than the average company). So, even if we assume an immediate and permanent 50% cut in dividends, GDP growth for the next 50 years could shrink 1.4% per annum and the British government would still break even.
Can economic prospects really be that bad? It’s possible, I suppose, but unlikely.
Published in Investment Letter, August 2016
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.