New exercises in decomposition analysis

Decomposition analysis, which breaks down the Total Return on an asset into constituents of Income Yield, Income Growth and the Revaluation Effect, can be used prospectively and retrospectively. To date, it has been mainly applied retrospectively to Equities. In this article, we break new ground, demonstrating that, with appropriate data series, it can be extended to Bonds, which means that Equity and Bond returns and their constituents can now be compared on a like–for–like basis. Empirical analysis of UK Index data since 1976 produces some unexpected results on Fixed Interest and Index–Linked Gilts: for example, throughout the period, the Revaluation Effect has been a consistently significant contributor to the Total Returns of both classes and at a much higher average level than that for Equities; also, the Revaluation Effect for Index–Linked Gilts has recently been at an unprecedented level for any asset class. Seeking to explain them, we examine the role of regulatory activity, arguing that it has created a dangerous dynamic on unsound foundations. We demonstrate that our method of analysis does not consist only of technical operations devoid of practical applications but actually enables us to address important issues in economics and political economy.