This article was writtne by Chris Gilchrist and published in The IRS Report in November 2011

Gilts may keep on bubbling

It is easy to argue that no sane investor should buy a 10-year gilt with a gross redemption yield of 2.6% when inflation is running at over 5%. Even if you believe the Bank of England's Governor Mervyn King, who keeps on arguing that imported inflation will wash out of the RPI next year, inflation will likely still average 2% or more for the next few years. On that basis gilts look sure to produce losses in real terms of net of tax if held to redemption.

But these are not normal times. As Professors Reinhart and Rogoff tell us in their authoritative survey of 300 years of financial crises "this time it's different", balance sheet recessions are followed by "financial repression". Governments force or encourage institutions to hold more government debt, thus driving down yields.

This has the benefit of permitting governments to borrow more than would be possible at realistic interest rates - realistic in the sense of giving a real return to investors. It also permits banks to rebuild capital by borrowing from central banks at the near-zero official rate and lending to the government at 2.5%. Such recapitalisation by stealth avoids the unpleasant necessity of confronting voters with the hideous reality of the gigantic write-offs needed to make banks genuinely solvent.

Martin Wolf keeps reminding people in his FT articles that 100 years ago, banks commonly held equity of 20% and kept 30% of their cash in safe assets like Treasury bills and bonds. Even the proposed is, in the long run, too low to dreate "safe banking". There is much more pain ahead for banks and their investors.

The way Eurozone leaders have dodged and fudged in order to avoid actually having to stump up any real cash is indicative. I believe financial repression is a certainty. New EU insurance capital rules will force insurers to hold more government bonds; a few tweaks to pension rules will send the pension funds in the same direction. Banks will pledge collateral with central banks in return for cash at 0.5%-1% and use it to buy government bonds.

Analysts will shriek about the ratio of debt to GDP, but Japan has already shown that governments can keep on borrowing to far more than 100% of GDP without facing disaster. This is not just because most Japanese government bonds are domestically owned; in practice the government can easily afford to pay its interest bill at ludicrously low interest rates, and that is what counts. For the eurozone as a whole, the same logic applies - or would do, if collective borrowing with eurozone bonds was allowed, as it probably will be when other options fail.

All this adds up to the familiar argument that Europe (though possibly not the US) faces a decade of low growth and rising government debt, just like Japan. Possibly, too, government bond yields could fall by another 1% to leave 10-year yields at 1.5%. The gilt bubble may have more life in it yet - though it is now a far riskier game.

What is different about Europe now compared with Japan in the 1990s is that Europe has a stronger equity culture and many more solid blue-chip companies paying big fat dividends. Even if growth slows and profits fall, most of these cash-rich companies are likely to go on paying dividends rather than cutting them and leaving themselves exposed to opportunistic takeovers financed by the capital still in the hands of the casino bankers.

In Japan, such value stocks outperformed the Nikkei index pretty consistently for a whole decade. But the relative performance argument is only relevant to fund managers. For individuals the key factor is the sustainability of the dividends and the possible rate of increases, as Douglas Moffitt points out on page 2. My conclusion is that if you were going to leave your grandchildren an inheritance to cash in in 2040, of all the investments you could choose these blue chip shares must have the best risk-reward ratio.

If you do not want to select such shares yourself, then leave it to experienced value investors like Neil Woodford at Invesco Perpetual Income (and Edinburgh Investment Trust), Tony Nutt at Jupiter Income, Adrian Frost at Artemis Income, Leigh Harrison at Threadneedle UK Equity Income, the Aberdeen team at Murray Income Investment Trust or Angela Lascelles at Value & Income Investment Trust. Internationally-investing open-ended funds with a similar remit and sound management teams are M & G Global Dividend and Threadneedle Global Equity Income.

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