Back to the Future for Dividend and Bond Yields

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The Demographics of Deflation

It was also an era of strong economic growth and technological innovation. The auto and housing industries boomed, the chemical and pharmaceutical industries thrived, and the Go-Go years weren't far off. The combination of higher inflation and stronger growth expectations drove bond yields far above dividend yields. "Amazing? Not when the experience of 1958 had confirmed that the deep deflationary depressions of the old days were gone forever," Bernstein wrote in a 2005 newsletter. "Now investors could buy stocks for growth, for the long-run, to hedge against inflation, and not just for buy-low, sell-high."

Fast forward to today. It almost appears to be the mirror image of 1959. There is serious discussion about the prospect for a deflationary downturn. The core consumer price index—the CPI minus volatile food and energy—was up a mere 0.9 percent year-over year during July, matching the smallest increase since 1966. The outlook for growth is also subdued, with households struggling to pay down debts and government facing the need to put its fiscal house in order. And where the Baby Boom generation's onset powered economic growth in the early postwar decades, the same generation's aging could weigh on the economy in the decades to come. "Demographics are the rarely acknowledged 800-pound gorilla," says Robert D. Arnott, chairman of Research Affiliates. "Fewer working-age people will result in lower [gross domestic product] growth."

It's too early to say that the "aberration" of 1959 has reversed itself for the long haul. The ominous combination of slow growth and deflationary pressures has pushed bond yields down to very low levels. A survey of stock and bond market history also suggests that when inflation is the primary price force, the dividend yield will be below bond yield; when deflation rules, the opposite relationship holds. Certainly it's hard to see much gain left in bonds after the latest flight to safety.

Meanwhile, the same combination of forces suggests that it will be tough for many companies to find good investment opportunities for their cash. Managements may well have to offer higher dividend yields to entice investors in the future. With a generation of investors burned by the dot-com bust, the credit-crunch bear market, and the disappointing experience of a decade-long return on equities of -0.95 percent, it may take higher dividend yields to entice them back into the equity fold.

Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on Businessweek.com.

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