At the turn of the millennium, Warren Buffett offered some typically wise words of reassurance to investors at the Berkshire Hathaway annual meeting.

Buffett, then 70, said: ‘The best time to buy stocks… has been when interest rates were sky high, and it looked like a very safe thing to do to put your money into Treasury bills … As attractive as that appeared, it was exactly the wrong thing to be doing. It was better to be buying equities at that time, because when interest rates changed, their values changed even much more.’

Interest rates have risen meaningfully in response to higher inflation. In the UK, the MPC has increased interest rates from less than 1% to 4.25% in less than a year. Ten-year gilt yields have risen from 1.5% to 3.4%. Investors are turning to fixed income assets proclaiming that last decade’s popular mantra of ‘there is no alternative’ to equities is broken as risk-free rates have risen towards dividend yields. 

I believe this view is misplaced. Equities continue to offer the most attractive prospective returns and are the best long-term hedge against inflation. Warren Buffett was reflecting on this in the 1980s when interest rates reached over 14%. With interest rates just at 4% today, his argument remains valid.

Let’s start with fixed income. Today, you could put your money into a one-year fixed term savings account with NatWest (NWG) and earn 4%. Tying your money up for two years would only increase this to 4.1%. 

Both options have a liquidity drawback ­– you cannot withdraw your money without being penalised. For a more liquid, but perhaps more complicated, option, you could invest in 10-year UK government bonds, yielding 3.4%. If inflation was to run at an annualised 2% (the Bank of England’s official target), you would make a 1.4%-2% real return on these three options.

If you wanted to neutralise the risk of higher inflation, you could invest in an index-linked government bond instead, which at today’s prices would offer you a real return of -0.1%. It is a statement of fact that this security, held to maturity, is guaranteed to lose you money in inflation adjusted terms.

What about equities? As a reminder, an equity is a perpetual claim on a company’s cash flow and earnings. This means that, despite being amongst the most liquid securities in the world, equities are also, by definition, the most long-term in their fundamental nature.

Forecasting returns in equities poses a couple of issues as returns are 1) unspecified, 2) uncertain, and 3) not guaranteed. In a nutshell, it is often only in hindsight that you really know whether you have invested in a Google or a Yellow Pages.

Equity holders demand an additional return for the risk that they accept. This is known as the equity risk premium. One proxy for this is the difference between the earnings yield of a company (the inverse of its price/earnings ratio) and 10-year inflation-linked (index-linked) bonds.

Why index-linked bonds? Nominal bond coupons cannot grow. Whereas in the long term, corporate profits tend to grow in real terms – ie, by more than inflation. Why earnings not dividend yields? This is because corporates generate earnings that they do not immediately pay back to you through dividends but which they can use to create value through reinvesting in the business or through buying back their own shares at below their intrinsic value. Apple, for example, has created tremendous value through share buybacks, not dividends.

The chart below shows the earnings yield on the FTSE All-Share (10%) and 10-year index-linked gilts (0%). This 10% spread is one measure of the equity risk premium, or what you are implicitly being paid to invest in equities relative to bonds. It is at an attractive level in both absolute and relative terms. Note that the spread averaged just 4.7% between 1997-2007, in a period of more normalised interest rates.  

Let’s illustrate this with a practical example.

NatWest shares trade on a 20% prospective earnings yield (ie, a price of five times earnings) and have a dividend yield of over 7%. The equity risk premium, by my definition, is 20%. Why is this so high? Bank earnings are cyclical and hard to predict. The UK has been an unpopular equity market since the Brexit vote in 2016. We have recently seen bank failures in the USA (and arguably Switzerland), which have occurred almost completely out of the blue.

Investing in banks is never without risk, but this spread is a significant compensation for those risks.

I would rather have money in NatWest shares possibly earning 20% and with the prospect of future earnings growth) than in a NatWest account definitely earning no more than 4%.

This is the last point to remember and one that Buffett has always talked about. Equities really should be thought of as a long-term savings account with high returns. But their values fluctuate in the short term, sometimes wildly so. The reality is that when they fluctuate lower, their prospective returns usually increase. It is against human nature to be drawn to investments that are falling in value, because we are wired to be more sensitive to losses than gains, but it is often the right thing to do in the pursuit of long-term returns.

UK equities have been volatile since 2016 and bonds now offer you a recognisable nominal return for the first time in 10 years, but do not let that distract you from the fundamental maths: equities should offer attractive prospective returns from here.

Kartik Kumar is co-manager of the Artemis Alpha (ATS ) investment trust, which holds shares in Natwest Group.

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