The Long View: The bulls have their say
by Philip Coggan / London January 23, 2006
The bulls are developing a new line of argument. Three years after share prices reached their nadir, there are increasing signs of investor confidence. At the heart of the argument is the emerging economies of India and China.
Those two countries are pushing up the rate of global economic growth while, at the same time, thanks to their low costs, keeping the lid on inflation. The result is an improvement in trade-off between inflation and growth that ought, the bulls believe, to be reflected in share prices. The argument was neatly summed up this week by Jim O’Neill, head of global economic research at Goldman Sachs. It is best explained in terms of the “equity risk premium”, the excess return investors should demand for holding a volatile asset such as shares. The expected return from equities, as regular readers will know, is equal to the dividend yield plus dividend growth. It is natural to assume the latter rises in line with economic growth (although this has not been borne out by the historical data).
So, in the US, with the dividend yield at 1.8 per cent and real GDP growth expected to be 3 per cent, one would expect a real return from equities of 4.8 per cent. As real bond yields are 2 per cent, that suggests an equity risk premium of 2.8 per cent, not that high by historical standards. At the global level, if one assumes 2.5 per cent annual growth, the equity risk premium is about 3 per cent. But if one believes India and China can push global growth to 4 per cent, then Goldman thinks the risk premium becomes a more attractive 4.6 per cent. That equation makes equities look a lot more appealing.
A parallel argument made by the Gavekal economic consultancy is that the nature of the economic cycle has changed. Cycles in the western economies used to be dominated by the manufacturing sector, which has high fixed costs and tends to build up large amounts of inventory. As demand fluctuates, such companies move swiftly from profit into loss (and vice versa) and also alter production in response to changes in inventories, with knock-on effects on employment and thus on consumer demand.
Modern economies are more service-dependent with manufacturing outsourced to economies such as India and China. Changes in demand are thus not quite so important for companies in developed economies, as their sub-contractors can bear the strain. If the economy has become less volatile (as appears to have been the case over the last 13-14 years), it makes sense that investors should demand a lower risk premium from their assets.
In other words, valuations can be higher. Even in markets where the price-earnings ratio is above the historical average, bulls argue, investors should not worry. A related argument is put forward by Kevin Gardiner, the head of global equity strategy at HSBC. He says profits can remain higher, as a proportion of GDP, than we have been used to in recent decades.
“If you examine any long-term data, then the share of profit of GDP or the return on equity looks worse in the 1970s and early 1980s,” he says. “That was because companies faced the combination of horrible growth and rampant cost-driven inflation.” Things have gradually improved in recent years, Gardiner argues, with costs now being controlled by globalisation (China and India again). Indeed, one could say that the corporate sector has won, and the labour sector in developed economies has lost, from this process.
At the same time, the corporate sector has developed a much stronger focus on return on capital, while economies have been liberalised and deregulated. In theory, if profits as a proportion of GDP are high, then more businesses will be created and returns will eventually be driven back down. But Gardiner says this is a very long-term process. Add these arguments up and you have a world with stronger and less volatile economic growth, in which profits can remain high.
Bulls also rely on more traditional arguments, such as the relative valuation of equities compared with bonds, and the prospect that dividends, share buybacks and takeovers will bolster demand for equities this year. All this may explain why equity markets have started the year so well, although there was nasty hiccup in Japan this week. Of course, the bears have an alternative explanation for events and we shall turn to their views next week.
Postscript
In the past, this column has suggested that UK investors should buy index-linked gilts as a hedge against inflationary pressure and as a base for their post-retirement income.
But that advice does not apply at current yield levels. During the week, yields on the 2055 issue got briefly below 0.4 per cent as a squeeze appeared in the market, with pension funds trying to match their liabilities and other investors being forced to cut losing positions. It makes no sense to lock in a real yield of less than 1 per cent for such a long time, when even cash has historically delivered better returns.
The best UK investors can do at the moment is buy five-year index-linked National Savings certificates which offer a real 1.05 per cent tax-free. If we assume a 2.5 per cent inflation rate, then a 40 per cent taxpayer would beat cash, assuming base rates stay at current levels.
