Peter Bickley : Bonds are thriving strangely well in a world of their own

It's a funny old world out there in the markets. What's good for one type of asset is often bad for another. Asset allocators rely on these differences and great effort goes into studying historical correlations. Like most pseudo science in the investment world, the process is quick to generate complex statistical models that cannot go wrong. That's why we all came through 2008 unscathed. Well, that was the plan.

All assets are economically sensitive but they respond differently. The contrary reactions of real versus monetary assets aren't just historical observation; they are entirely logical. So it is unsettling when, as now, normal service seems to be suspended.

Equities are doing nicely; commodities are strong; and gold is at a high. This should all be symptomatic of roaring economic strength, a condition usually toxic for bonds. Yet the 10-year UK gilt yields 2.89 per cent, rather less than inflation. Bonds are enjoying another great year. This is an offence to the natural order of things. The conundrum is spotting the odd man out.

Most developed economies face extended cold turkey. In the UK it'll be worse, so crazily did we binge. Household budgets and corporate profits will be squeezed while inflation stays well north of target. Risk assets exposed to this don't, on the face of it, have much appeal. Economic depression is good for bonds but when the inflation-adjusted yield is negative you have to wonder who is smoking what. And it's not as though bonds aren't being printed any more; the Treasury is dishing them out by the shed load.

Contrary to appearances the behaviour of all these assets is rational. What we'll find, though, is that rationality may lead to undesirable investment outcomes.

Bonds are in a world of their own. With the base rate stuck at 0.5 per cent, the yields on near maturities cannot climb far. Longer yields could be higher but the markets know that underlying inflation is nothing like as high as it looks. Today, bonds do indeed look rational.

Equities - or some of them - have their sights elsewhere. UK prospects are dreary but the global economy is doing well. The growth isn't here any more, it's in the emerging markets. Equities and commodities are driven by opportunities elsewhere. Monetary and real assets can both climb together, provided they are being driven by different factors which, crucially, are not mutually incompatible.

So what about those "undesirable investment outcomes"? Best laid plans go pear-shaped for two principal reasons: something comes out of the blue and transforms the operating environment or, more commonly, obsession with rationality blinds us to objective value. Today we should take each seriously.

The spectre at the feast is gold, a pretty useless investment unless you lack confidence in paper money.The gold price tells us that money has doubters. If they are right all our risky assets could be in deep trouble. (I don't think they are, but a bit of insurance never comes amiss).

This leaves value, which cuts two ways. At some point our economy will start to hum a bit louder and 2.89 per cent on 10-year UK gilts will look absurd. When the time comes expect capital losses on an epic scale.

Those of us not clever enough to spot the right exit point might choose not to be involved. The flip side is that, however challenging the outlook, apparently perverse investment choices can be sensible if the pricing is right. Equity exposure to a depressed UK economy might look an unlikely bet, were it not for the scope to pocket high, secure and rising dividend streams.

Bonds, equities, commodities and gold make unlikely bed- fellows. Each has its rational case for going upwards but ultimately they cannot all be right. Each has its risks but for me the odd man out is the one the markets love most - bonds.

• Peter Bickley is a consultant economist