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OPINION

Big risks to equities

Big risks to equities
April 4, 2022
Big risks to equities

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 only 2.2 per cent from February’s peak, but up slightly since the autumn and 9.2 per cent higher than a year ago. Granted, this is partly thanks to great performance by giant stocks such as Shell, HSBC and the big miners. The FTSE 250 is 12 per cent down from September’s peak, but even it is up by 11 per cent in the last three years, which is bang average.

You would never guess from any of this that inflation is heading towards a 41-year high and that we face what Bank of England Governor Andrew Bailey has called “a historic shock to real incomes”.

There’s a reason why equities are holding up well. Economists believe households will respond to lower real incomes by borrowing more or by running down the savings they built up during the pandemic. The OBR forecasts the savings ratio falling to a 60-year low, and latest Bank of England data do indeed show that consumer borrowing rose in February. If they are right, spending will grow faster than wages in real terms, which will support corporate profits.

This, however, poses a question: if equities are resilient to high inflation and falling real household incomes, what are they not resilient to? Where does equity risk come from?

Looking at day-to-day moves, the answer is: investors themselves. As we saw in early March, prices can fall a lot because of what Stanford University’s Mordecai Kurz calls endogenous uncertainty – investors worrying about other investors worrying.

Day-to-day 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 have estimated that 10 of the 24 main national stock markets that existed in 1931 subsequently suffered long-term closure. This is no mere historic curiosity. One reason why UK equities did well after the 1970s was that the risk of socialism or nuclear annihilation became priced out. But this means that long-term historic returns are an overestimate of likely future returns.

If we leave these risks aside, there are three other threats to equities.

One is recession. Falls in GDP are associated with significant falls in equities. For example, between February 2008 and March 2009, real GDP fell 6.6 per cent and the All-Share index fell 34.1 per cent. And between October 2019 and April 2020 real GDP fell 25.3 per cent and the All-Share index 18.3 per cent.

A second risk is valuations. When the tech bubble burst in 2000 the All-Share index fell 45 per cent from peak to trough and did not return to its December 1999 level in nominal terms until 2007. Adjusted for inflation, the index is still well below that peak: all the real returns on UK equities this century have come only from dividends. And the UK is not unusual here. The US’s Nasdaq index only returned to its 2000 peak in 2015, and Japan’s Nikkei 225 index has never returned to its 1989 level.

Devaluations, then, can wipe out returns for a large chunk of your investing career. Which is why it is troubling that the dividend yield on the All-Share index, at 3.1 per cent, is well below its historic average.

If these sources of equity risk are obvious, there’s one that’s less obvious but nevertheless important.

To see it, ask why equities have (so far) been resilient to rising inflation now when they slumped during the high inflation of the 1970s.

It’s because there’s a big difference between then and now. Back then, inflation was accompanied by a squeeze on profit margins. The share of profits in GDP, which had for years been stable around 20 per cent, fell below 15 per cent in 1974-75. That didn’t mean only lower corporate earnings. It meant lower expected growth as the motive to invest was extinguished and increased political risk as the survival of capitalism was called into question.

By the same token, as the profit share recovered so too did equities. New York University’s Sydney Ludvigson and colleagues have shown that, in the US, the main reason for soaring share prices since the 1980s has been not economic growth or falling interest rates but rather a redistribution of incomes from workers to company owners.

Factor share risk – changes in the distribution of incomes going to labour and capital – is a big source of longer-term share price moves. Talk of class conflict is unfashionable, but that doesn’t mean it is unimportant.

And it is a risk right now. Many economists – not least the OBR – believe the profit share will hold up because spending will rise faster than wages*. This could happen. But it’s not guaranteed. If the pandemic has tipped us into more frugal habits (such as eating and drinking at home rather than in pubs or restaurants); if people fear the income squeeze will be more than temporary; or if they just cannot borrow except at usurious rates; then spending might not rise much more than wages. Which would mean a squeeze on profits.

Yes, this is just a risk. But that’s the point. We shouldn’t be fooled by the market’s current resilience. There are bigger dangers to equities than inflation.

*Some simple national accounts arithmetic should clarify this. GDP is equal to the sum of consumer spending, investment, government spending and net exports:

Y = C + I + G + NX.

It is also equal to the sum of wages, profits, other incomes such as those of the self-employed, and taxes:

Y = W + P + O + T

Rearranging these gives us an identity for profits:

P = (C – W) + (I – O) + (G -T) + NX.

Which tells us that a rise in consumer spending relative to wages, helps to raise profits.