By Simon Edelsten manager global equities at Artemis IM.
We cannot be sure what the next decade holds, but history suggests this period of high inflation and interest rates is unlikely to be the same as the last. You may need to adjust.
We like clumping history into eras: the Anglo-Saxons (beat the Norwegians in the semis and then lost to a team led by William of Normandy); the Normans (boo); the Tudors (tough time for monks and royal wives); the Victorians (empire – from conquered to conquerors).
The stockmarket seems to have its eras, too. In my time we have had the 1980s (big bang, inflation, long lunches); the 1990s (technology boom); the 2000s (technology bust, banks boom and bust); the 2010s (quantitative easing, incredibly low interest rates and inflation).
It looks like 2023 will be the first full year of a new investing era – marked by the return of inflation and higher interest rates and attempts to retreat from quantitative easing.
Inflation and interest rates
We are approaching the anniversary of several inflation spikes, particularly those caused by Russia’s invasion of Ukraine. The price of Brent crude hit $128 last March and is now around $85 so fuel-related items (there is a large fuel element in food prices and building materials) may have a helpful impact on headline inflation through the first half of 2023.
The inflation prompting the most concern is wage inflation. Employment levels are high across the bulk of developed countries, and the rising cost of living brings calls for higher pay. Central bankers worry that these demands, though credible, may fuel an upwards spiral in wages, driving further price rises, as happened in the late 1970s.
It seems unlikely that interest rate rises will be reversed soon. Economies must adjust to a ‘new normal’ level of interest rates – above 4% in the UK and US and above 3% in Europe. These are not high in historic terms – UK rates have averaged around 5% since the 1990s. But they are a lot higher than we have become accustomed to since the 2008 financial crisis.
The pain of adjustment
Change points are often when economies and investors feel the most pain. The classic sector to suffer when interest rates rise is property – commercial and residential. For new home buyers, 2022 was particularly tough.
When I bought my first flat, property was cheaper, but the mortgage rate was around 10%. A mid-1980s inflation spike took it to 15%. My monthly payments shot up from around a third of take-home pay to over half. I tightened my belt for a couple of years (fortunately, my waist was a couple of inches slimmer then). I fear for those renewing mortgages today, with higher levels of debt and rates tripling to more than 5%. Belt tightening may not cover the deficit.
Governments must also adjust to sustained higher rates. As the UK’s Kwasi Kwarteng moment showed, bond markets are touchy. Welcome investment through the European Green Deal and the US Inflation Reduction Act is likely to be funded by debt costs more onerous than those originally planned, leaving less tax revenue for other priorities.
Impact on investments
What does this new era mean for equity investors? Loan rates for companies rise more sharply than bank rates – just as for mortgage holders. These higher costs come as margins may be being squeezed. The companies worst hit are those with lots of debt and unable to pass on fully the rising costs of materials and labour.
But sectors seemingly with little debt can also be strongly affected by higher interest rates. Young technology companies, including those in biotech, have enjoyed plentiful funding from patient venture capitalists over the past decade. When these investors hear the ticking clock of 4% interest rates, they become less patient and less open-handed, sometimes pulling funding from promising projects simply because the time and expense of the commercialisation phase may seem too great a risk.
The combination of rising rates, a weak economy (making selling new products tough) and lower equity market valuations compounds the problem.
Unsurprisingly, many investors are looking for companies with low debt, high-profit margins and strong pricing power. That may lead them towards some of the world’s largest, quoted companies. Understandable – but not without risk. Remember, new eras also tend to mean a new cast of leading global corporate players.
The largest companies in the world today are Apple, Microsoft, Alphabet (Google), Amazon, Tesla, UnitedHealth, Exxon Mobil and Johnson & Johnson. Of these, only Amazon has much net debt – Exxon normally has net debt but has had a bonanza year with high oil prices.
Technology stocks on this list saw sharp share price falls last year. Partly they had reached excess valuations, but also their growth rates disappointed. Some are also now having to rein back costs to maintain margins. However, their ability to carry on making good profits is only modestly affected by rising interest rates, higher inflation or a slowing economy. The selection my team owns includes Microsoft, Alphabet and a modest position in Apple.
Edging towards the global top 10 is TSMC, the world’s biggest advanced chip maker. It has pricing power and also seems reasonably valued – at 12x earnings with a 2.5% yield. It even has net cash on the balance sheet. In every sense, then – technologically and financially – it looks to be a new era company. So does ThermoFisher Scientific. Though ‘only’ a $200bn company, it provides much of the equipment needed for biotech and materials science.
Perhaps a surprise shout for a new-era company is Mitsubishi UFJ. In eras past Japanese banks regularly featured in the global top 10. A few interest rate rises would massively improve its profitability. If it traded on the same price-to-book as American banks it would be valued at ¥2,000 – not ¥820, as it is today. Its book value per share is ¥1,350, so it looks like you get a lot of company for your money and 3.8% yield in yen.
We cannot be sure what the decade ahead holds, but history suggests this new era is unlikely to be the same as the last. You may need to adjust your portfolios…