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Furlough, job losses and future returns

Diageo (DGE) has revealed an improved trading outlook for the spirits giant’s June 2021 year-end, achieved despite unprecedented commercial disruption to its sector (with the exception of prohibition in the US). The group’s shares have shed 18.2 per cent of their value over the past 12 months, following on from their all-time high recorded midway through August 2019.

The FTSE 100 is down by around a fifth over the same period, so this relative outperformance by Diageo, no matter how modest, still points to the defensive nature of the stock, particularly in light of how the various lockdowns hollowed out the global hospitality industry.

The reliability of the group’s revenues and cash flow has enabled it to crank up leverage to support an acquisitive business model. Net borrowing was equivalent to 157 per cent of shareholders’ funds at the group’s last year-end, a level that curiously enough falls into line with that of a number of the privatised utilities. This may suggest that we are as reliant on booze as we are on electricity or mains water.

Whatever our collective relationship with the bottle, there will probably be plenty of workers drowning their sorrows when the government’s furlough scheme expires at the end of October, even though other job support schemes are being put in place. Whether these measures will help to minimise redundancies is difficult to say, particularly with a second national lockdown still in play.

The Bank of England has previously warned that 2.5m people could be out of work by the end of the year. This estimate looks unduly upbeat given that the number of people claiming benefits increased by 120 per cent to 2.7m from the commencement of the lockdown through to the end of August. Projections from the Office for Budget Responsibility paint an even grimmer picture, with the UK unemployment rate pushing towards the 10 per cent mark even under its most optimistic scenario.

Faced with the prospect of mass unemployment, it may be instructive to remind ourselves what effect joblessness on this scale has had on equity valuations in the past. Statistics over several decades point to a clear inverse correlation, but there is also a demonstrable effect on subsequent stock market returns to take into consideration.

Low unemployment is both a cause and an effect of good news in the economy –– and it has an indirect bearing on index values. When things are looking up, investors are willing to pay a higher multiple for a given level of earnings, leading to below average forward returns. The opposite dynamic also applies, which explains why superior rates of return on the stock market have historically come on the heels of periods of high unemployment. That is worth keeping in mind if numbers do, indeed, expand rapidly at the end of the month.

The forward-looking S&P 500 index lost a third of its value ahead of the release of the dire US job figures published in May, but quickly regained its lustre and is now only slightly adrift of the year-high recorded in the third week of February. The conclusion to be drawn is that market participants believed that US unemployment had peaked and the economy had bottomed out – initially, at least, their assumptions appeared to be on the money. 

US employment statistics have generally been heading in the right direction through the second half of the year, but there is an alternative theory that the recovery in the index was primarily due to a growing disconnect between the performance of the most heavily weighted constituents within the index and metrics from the wider economy. Covid-19, or rather the lockdowns that ensued in its wake, have accelerated job losses in areas of the economy that were already feeling the heat due to disruptive digital applications.

It is a compelling argument in a sense; how else do you explain the outsize influence of the FAANGS on index values in recent times? However, it would be disingenuous to suggest that valuations for the likes of Amazon (US:AMZ) are immune to the knock-on effects of rising unemployment. Generally speaking, consumers need to be in work to fund their consumption. And unemployment rates in several western economies are likely to approach levels not seen since the early 1980s when the initial ill-effects of deindustrialisation became apparent.

It may be that ‘big-tech’ has cleaved a wider gap between equity markets and general economic performance, but it would be unwise to ignore the inverse correlation between unemployment and index valuations. It may well resurface if we witness a prolonged slump in the jobs market, thereby providing a clearer indication of where stocks are headed next.