Something remarkable has happened to UK equities – the remarkable thing being that nothing remarkable has happened. As I write, the All-Share Index is down just 2.2% from its February high, but up slightly since the fall and 9.2% higher than there was. one year old. Admittedly, this is partly thanks to the excellent performance of giant stocks such as Shell, HSBC and the big miners. The FTSE 250 is down 12% from its September peak, but has even risen 11% over the past three years, which is an exceptional average.
You would never guess that inflation is heading for a 41 year high and we are facing what Bank of England Governor Andrew Bailey has called “a historic shock to real incomes”.
There’s a reason stocks are holding up well. Economists believe households will respond to falling real incomes by borrowing more or depleting the savings they have accumulated during the pandemic. the OBR predicts that the savings rate will fall to its lowest level in 60 years, and the latest data from the Bank of England indeed shows that consumers loan pink in February. If they are right, spending will grow faster than wages in real terms, supporting corporate profits.
This, however, begs the question: if equities are holding up to high inflation and falling real household incomes, what are they not holding up to? Where does equity risk come from?
Looking at day-to-day movements, the answer is: the investors themselves. As we saw in early March, prices can drop a lot because of what Stanford University’s Mordecai Kurz calls endogenous uncertainty – investors worry about other investors.
Overnight volatility, however, cancels out over time. Over longer periods, there are other dangers for equities.
Historically, the most important of these have been wars or military defeats. Philippe Jorion and William Goetzmann estimated that 10 of the 24 main national stock exchanges that existed in 1931 then suffered durably closing. This is not a simple historical curiosity. One of the reasons British stocks did well after the 1970s was that the risk of socialism or nuclear annihilation became unaffordable. But this means that long-term historical returns are an overestimate of likely future returns.
Leaving these risks aside, there are three other threats to equities.
One is the recession. Declines in GDP are associated with significant declines in equities. For example, between February 2008 and March 2009, real GDP fell by 6.6% and the All-Share Index by 34.1%. And between October 2019 and April 2020, real GDP fell by 25.3% and the All-Share Index by 18.3%.
A second risk is that of valuations. When the tech bubble burst in 2000, the All-Share index fell 45% from peak to trough and did not return to its December 1999 level in nominal terms until 2007. Adjusted for inflation, the he index is still well below that peak: all real returns from UK equities this century have come only from dividends. And the UK is not unusual here. The U.S. Nasdaq index only returned to its 2000 peak in 2015, and the Japanese Nikkei 225 index never recovered to its 1989 level.
Devaluations can therefore wipe out the returns of much of your investing career. That’s why it’s troubling that the All-Share Index’s dividend yield, at 3.1%, is well below its historical average.
While these sources of equity risk are obvious, there is one that is less obvious but nonetheless important.
To see this, ask yourself why stocks have (so far) withstood rising inflation now that they crashed during the high inflation of the 1970s.
It is because there is a big difference between yesterday and today. At the time, inflation was accompanied by a squeeze on profit margins. The share of profits in GDP, which had remained stable for years around 20 percent, fell below 15 percent in 1974-75. This didn’t just mean lower corporate profits. This meant lower expected growth as the motive to invest was extinguished and increased political risk as the survival of capitalism was in question.
Similarly, as earnings shares have rallied, stocks have also risen. Sydney Ludvigson and her colleagues at New York University have shown that in the United States the main raison because the surge in stock prices since the 1980s has not been due to economic growth or falling interest rates, but rather to a redistribution of income from workers to business owners.
Factor share risk – changes in the distribution of income going to labor and capital – is an important source of longer-term movements in stock prices. Talking about class conflict isn’t fashionable, but that doesn’t mean it’s not important.
And that’s a risk right now. Many economists, including the OBR, believe that the profit share will hold as spending will grow faster than wages*. It could happen. But it is not guaranteed. If the pandemic has made us switch to more frugal habits (like eating and drinking at home rather than in pubs or restaurants); if people fear that the income squeeze will only be temporary; or if they simply cannot borrow except at usurious rates; then expenses might not increase much more than salaries. Which would mean a squeeze on profits.
Yes, it’s just a risk. But that’s the point. Don’t be fooled by the current resilience of the market. Equities are more at risk than inflation.
*Some simple national accounts arithmetic should clarify this. GDP is equal to the sum of consumption expenditure, investment, government expenditure and net exports:
Y = C + I + G + NX.
It is also equal to the sum of salaries, profits, other income such as that of the self-employed and taxes:
Rearranging these gives us an identity for the benefits:
P = (C – W) + (I – O) + (G -T) + NX.
Which tells us that an increase in consumer spending relative to wages helps to increase profits.