19 Oct 2022
Simon Edelsten considers whether the bleakness of the headlines suggests it is time to go on a spree. The numbers, however, are more confusing...
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Stuffed in a memento box on my shelves at home somewhere, I have an invitation to a wake that never happened. It was an open-dated invitation to a drinks party in the City, sent in early 1985, to take place the day the pound sank to parity with the dollar. On 6 February, sterling hit a nadir of $1.05. I am still waiting for my wine.
Sterling’s recent fall encourages me to search out that invitation. It also reminds me that I am growing older. But age does give you a larger frame of reference. The world looks bleak but some of us have been here before.
Today I am looking and asking, have markets tumbled enough to look tempting? If you buy on bad news, then the bleakness of the headlines would suggest it is time to go on a spree. The numbers are more confusing.
Let’s look at the data. The MSCI All Country World Index is down over 25% per cent this year. The dollar’s strength has helped UK investors enormously. Global equities in sterling have only fallen 4.2 percent. This is hardly a disaster – especially given they are still nearly fifty percent higher over five years and have trebled over ten.
It may surprise you to hear that only three per cent of sterling’s tumble of 17 per cent has come on the new Prime Minister’s watch. She has simply made a weak currency weaker. But Britain is not the only country with currency woes.
The yen has fallen by 29 percent this year and the Euro by 15 per cent.
On interest rates, the Fed has done what it promised – raise rates sufficiently to cool core inflation. US inflation has fallen to 8.3 per cent, modestly lower than the July peak, helped by oil prices falling from over $120 a barrel to the mid $90 range and gasoline from $5 to $4.
A couple more half-per-cent lifts over the next two months would bring the Fed’s base rate to 4.25 per cent – a suitable pausing point for a reflective breather, perhaps? High enough to cause a modestly hard landing but, given the strength of the labour market, not enough to crash the economy.
Meanwhile, UK inflation continues to rise, with CPI at 9.9 per cent in August. The Bank of England seems way behind the curve with interest rates at 2.25 per cent, though commercial banks are moving ahead of that – five-year fixed mortgage rates are now heading for six per cent.
Given the UK’s history of higher inflation and our weak currency (which makes imported goods more expensive, fuelling inflation and inflating fuel prices), interest rates and gilt yields may need to be higher than US rates before they attract global investor support. US 10-year Treasury yields are 3.9 per cent today and UK 10-year gilt yields 4.4 per cent. Not much compensation considering the different inflation and currency risks.
Some claim that equities, being stakes in the real world, can protect savings during a period of inflation. This is possible if your timing and the valuation is right.
Take the Volker period (the model the Fed seems to be following today). Between 1978 and 1982, when inflation was brought down from 11 per cent to 6 per cent, the S&P 500 with dividends reinvested returned 15 per cent a year while inflation averaged around seven per cent a year.
But what circumstances allowed this to happen? The S&P 500 fell sharply through the 1970s. The oil shock in 1973 had taken the index down from 120 to 62 in October 1974. By the start of 1978 many believed the oil price effect on inflation was fading, only to find that inflation was stubborn and persistent – enter Volker. The index started 1978 at 88, well off the lows, and ended 1982 at 140. According to Robert Schiller’s database, the PE on the S&P at the start of the period was around 9x earnings and the yield 5 per cent against 7.7% long interest rates.
The S&P trades at 15x next year’s earnings with a yield of 1.8 per cent compared with ten-year Treasury yield of 3.8 per cent. But there is an enormous difference in the composition of the index.
In the late 1970s it was dominated by highly cyclical, capital-intensive and indebted companies (with poor ESG records). Think General Motors, General Electric and Exxon.
The index today is dominated by Apple, Amazon, Alphabet and Microsoft. The lower indebtedness and higher return on equity justify a much higher valuation. The ability of these companies to cope with inflation may prove compelling to investors over the next year.
Now that the Fed is close to the level of interest rates needed to slow inflation, shares may be driven more by their underlying (real) cash-flow growth. This argument suggests US equities remain the best bet – despite the dollar’s strength and the index looking relatively expensive (PE of 15x for next year compared to 8.8x for the UK).
Not only is the monetary squeeze now in place, American consumers remain solid and the jobs market buoyant. These conditions do not apply to the UK or Europe, where rates need to rise much further and the consumer is showing understandable concern at mortgages and rents, and eye-watering fuel bills (despite government help).
Asia had seemed another haven from inflation, but China’s economy is showing little sign of recovery despite the housing market stabilising. Japan, with the yen at a level not seen since the 1980s, may well enjoy an export boom when other economies return to buying things. Valuations averaging 14x earning reflect strong balance sheets and world-class companies; a yield of two per cent pays you a little to wait.
Equities may not look a steal, but they have demonstrably protected savers from inflation. The US seems the safest home currently. Japan looks interesting; I wish I could say the same for the UK and Europe. Soon perhaps...
This article first appeared in Rankia Pro on 14 October 2022.
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