Recession is coming, although it may be a toss-up whether it reaches the UK or the US first. The price relationship between fixed-interest stocks and equities is broken. But, increasingly, it is becoming a stock-pickers’ market. How miserable – or otherwise – should these developments leave investors?
Depends which actually come to pass and how long each persists. Recession is around the corner, or so we keep being told, and it looks like materialising in the US before it arrives in the UK. In the US, inflation-adjusted output fell quarter on quarter in 2022’s first quarter, whereas it just scraped a positive figure in the UK. On that basis, the US could be in recession by the end of the week, when provisional GDP data for the second quarter has been released, whereas the UK is still a minimum of more than three months away. Whichever, financial markets are signalling the virtual certainty of recession since some short-term interest rates are higher than long-term rates.
This is the so-called inverted yield curve, a rare phenomenon which gets economists very excited. Normally – and logically – interest rates on long-term debt are higher than on short-term debt. After all, if, say, I lend to the UK government for 10 years (ie, I buy a gilt-edge stock with 10 years to maturity) then I want a higher return than if I lend for two years. Why else would I risk tying up capital for so much longer without extra compensation? However, occasionally something happens to mess up this relationship and higher rates are on offer on, say, two-year debt than on the 10-year variety.
That ‘something’ is usually about short-term rates rising dramatically. For example, take the situation in the US for the 10 months starting July 2006 (see chart). Rates on three-month US Treasury bills, the definitive risk-free asset, were higher than for 30-year Treasury bonds – thus the yield curve became inverted. The US central bank, the Federal Reserve, was getting deeply worried about an overheating US housing market so raised short-term rates. Simultaneously, the punters who put money on the line in bond markets were looking further ahead, to the likely implosion of the securitisation merry-go-round that sustained the housing market by lending its values a veneer of plausibility. As a result – and before the sub-prime mortgage market crumbled – even when short-terms rates quickly doubled, long-term rates barely moved since they had already anticipated declining demand for money in the future as recession closed in. The redemption yield on 30-year Treasuries, 5.0 per cent in July 2006 when the yield curve inverted, was 4.8 per cent the following spring when the inversion unwound. Long-term yields continued to fall thereafter although, by then, short-term rates were falling much, much faster.
The generic way to explain this is as an instance when the bond market’s savvy operators knew what was happening but the central bankers didn’t. Quite likely the generic explanation is applying itself to the current situation in the US, where the Fed risks raising rates more than it needs to. True, we may not be there yet, although there was already an inverted yield spread between 10-year and two-year US interest rates before the Fed was set to tighten further on 27 July. As the chart also shows, the yield gap between three-month bills and 30-year bonds is wider now than it was in early 2020. Even so, on both sides of the Atlantic the gap is much lower than its 16-year average and one good shove upwards to short-term rates by the central bank could push it back into inverted territory.
Understandably enough, the Fed’s overriding fear is of inflation entrenching itself at too high a rate. That must worry investors too, partly because of the damage it would do to the price relationship between equities and bonds. The more that inflation burrows its way into stagflation, the more it undermines the inverse price relation between those two; a relationship on which so many private investors’ portfolios depend to smooth out volatility in returns.
Recent research from data provider MSCI shows that equity and bond markets are starting to behave much as they did in the years 1978-82, which it labels The Great Stagflation. During that period price movements of equities and bonds ceased to complement each other and increasingly moved in the same direction, which too often was downwards. Equity prices responded to the lack of growth; bond prices to the excess of inflation. Thus bonds’ stabilising influence in a diversified portfolio was weakened.
By juxtaposing monthly returns of US shares and bonds in a scattergram, MSCI shows that 2021-22 is looking more like 1978-82 than like much of 2000 to 2020, the period that central bankers named – with characteristic hubris – The Great Moderation; a moderation in inflation they themselves claimed to have engineered. However limited the actual role of central bankers in inflation’s moderation, that period did, indeed, benefit investors wanting volatility reduction since growth came with a lack of inflation. That meant bond prices were resolutely steady even when they weren’t rising. So, for example, data for December 1997 to the present show a negative correlation of 0.4 between the monthly returns on equities and UK gilts. Very roughly that means the downwards linear relationship between these two was driven by one or other – it does not matter which – 40 per cent of the time. To put it more even loosely, they influenced each other quite a lot, and in the right sort of way for risk reduction.
Obviously, that seems to be changing, but if there is a silver lining, it may be that current equity markets are also stock-pickers’ markets. Again, MSCI provides the research. It suggests that “the opportunity for active managers to outperform the market through stock selection has increased over the past 12 months compared to the prior two years”.
As to why, that comes down to the extra volatility in share price changes as investors increasingly fret about war, inflation, supply shortages and any other factors that make their life both a misery and an opportunity. MSCI labels this ‘cross-sectional dispersity’ and explains that “if dispersion is low then stocks behave similarly, leaving limited opportunities for active managers to outperform the market through stock picking. Conversely, when dispersion is relatively high, opportunities for stock selection have increased potential”. It finds wider dispersion in the past year wherever it looks – from country to country, across investing styles and across industries.
The question is whether MSCI is telling us anything from which investors can benefit. Essentially, it says that because volatility in price changes is high, then beta is much less reliable than usual. Beta is the statistic that measures the average relationship between a so-called independent variable (for example, the market) and a dependent variable (a stock). The current problem is that the dispersion of individual price changes around their average – called ‘R-squared’ in statistics – is much higher than normal, making that average a poorer predictor of future price changes.
But if beta is less useful than usual, then the converse must apply – that alpha, which is supposed to measure a stock-picker’s ability, becomes more important. At least, that is the implication of MSCI’s research, but it is not necessarily so. A value for alpha won’t change just because beta happens to be based on especially volatile price changes. Beta’s quality will have no effect at all on alpha. That’s because – and for what it’s worth – in a linear equation of the slope-intercept form alpha is simply the point on the vertical axis where the beta line happens to intersect with the axis. As such, it is a sort of statistical discard that just happens to be enticingly suggestive within the context of investment analysis.
Despite this, in effect all active investors have no choice but to search for alpha. It has become the number that quantifies and defines their worth. I exaggerate, but I will be no exception when I turn my attention – as I must – to finding new holdings for the Bearbull Income Portfolio.
There is also the question of what to do about the fund’s holding in what was GlaxoSmithKline, now split into an equal number of shares in GSK (GSK) and in toothpaste and painkillers specialist Haleon (HLN). Haleon’s shares may look odd sitting in an income fund since their possible dividend for 2023, the first full year of independent operation, is likely to generate a yield of less than 2 per cent of the current 312p share price.
Meanwhile, the table below illustrates a nice symmetry between the value of what GSK shareholders owned before Haleon’s de-merger and the value of what they own now. Granted, it’s early days and all that, but the only difference in value is a loss of about £70mn, which might be accounted for by the fees paid to scores of City advisers. Nice work, if you can get it.
|Valuing the old and the new|
|Old GSK||New GSK||Haleon||Combined|
|Share price (p)||1,719||1,757||312||na|
|Shares out (m)||5,084||4,067||5,084*||na|
|Mkt Cap (£bn)||87.39||71.46||15.86*||87.32|
|*Pro-rata entitlement of GSK shareholders Source: Company documents|