Aim stocks have held up well this year. The FTSE Aim index is now slightly higher than it was at the start of the year, meaning that it has comfortably out-performed the FTSE 100.
Something else has also held up this year: inflation expectations. The gap between five-year conventional gilts and their index-linked equivalents is now 2.9 percentage points, only slightly less than in January, despite a deep recession.
These two facts are related, as my chart shows. Falls in inflation expectations are often accompanied by falls in Aim stocks – as we saw in 2008, 2011-12, 2014-15 and this spring. And rises in inflation expectations usually see Aim stocks do well for example in 2009, 2012-13 and 2016-17. The stability of Aim shares is thus connected to the stability of inflation expectations.
There’s a reason for this. Aim stocks, even more so than others, are driven by investor sentiment: when sentiment improves it is smaller speculative stocks that do best, and when it deteriorates it is these that suffer most. Sentiment, though, is cyclical: it improves in good economic times and falls in bad. But inflation expectations are also cyclical. Hence the correlation between the two – which in this case is not causality.
This explains two other facts. One is that there is also a correlation between inflation expectations and sterling. The pound is a riskier currency than many others and so it falls when investor sentiment deteriorates – that is, when we are in (or expected to be in) bad economic times. The pound therefore often does badly when Aim stocks do, which implies that foreign currency cash or bonds can be a decent hedge against Aim stocks.
The other fact is that the gold price often moves in the opposite direction to inflation expectations. For example, gold rose in 2007-08 and in 2011-12 as inflation expectations fell but fell in 2012-13 and 2016-17 as inflation expectations rose. This is exactly the opposite from what we’d see if gold were protection against inflation. But it is just what should happen if investor sentiment and inflation expectations are cyclical. The point of gold is that it protects us from bad times and increases in investors’ risk aversion, not that it protects us from fluctuations in inflation.
From this perspective, there is a massive difference between this year’s recession and that of 2008-09. Although this year has seen a much greater fall in GDP than 2008-09, inflation expectations and investor sentiment (and hence Aim stocks) have held up much better than they did then.
There’s a reason for this. And it’s an example of how there is such a thing as progress in economics. In 2008 investors feared that when interest rates fell to zero central banks would run out of ammunition to fight recession. They therefore feared a prolonged slump and a risk of sustained deflation. This caused big falls in both the prices of risky stocks and in inflation expectations: at its low-point the five-year breakeven inflation rate turned negative.
Today, though, things are different. We now know that even at zero interest rates the Bank of England has the weapons to fight inflation. Not only does it have the option of more quantitative easing but it can also use dual interest rates – lending to banks at negative rates on condition they lend on the cash on generous terms. And in extremis, it could simply write us all a cheque. This has put a floor under inflation expectations and also prevented the huge drop in investor sentiment which we saw in 2008-09.
In the 1990s, investors thought there was a “Greenspan put” – that equities were partly protected from losses because when prices fell the Federal Reserve would step in to support the economy. In the same way, there is now a “Bailey put”. Looser monetary policy can protect us from big losses. And this knowledge emboldens investors to buy riskier assets.
If all this sounds like good news for Aim stocks, it’s not.
One problem here is that aggregate demand and inflation expectations could fall back – say because we get a second spike in Covid-19 or simply because the recent recovery in demand proves to be a one-off. If this happens, sentiment and Aim stocks could also fall back. Yes, the Bailey put sets a floor here. But it doesn’t eliminate the risk: it is an out-of-the-money put option.
The other problem is that the Bank doesn’t only set a floor for inflation expectations and sentiment. It also sets a ceiling. If the economy recovers sufficiently to raise inflation expectations the Bank will tighten monetary policy, thereby capping both those expectations and Aim stocks.
Granted, there are get-outs in this scenario. The Bank could err on the side of tolerating inflation until it is confident that the recovery is strong and sustainable. Or – less likely in my view – we could get an economic upturn that doesn’t generate inflation. When this happened in the late 1990s, Aim stocks soared massively.
These, though, are possibilities not probabilities. Instead, history carries a warning for Aim investors. Since the market’s inception in 1995, Aim stocks have hugely underperformed main market ones, giving a total return in this time of just 12 per cent while the All-Share index has trebled our money. This warns us that investors usually pay too much for smaller speculative stocks.
Investing in Aim shares is, therefore, a bet that the past is no guide to the future. While this bet might pay off in the near-term – momentum being a powerful thing – it is not one I would want to make for very long.
