Published in the Financial Times 27/10/2018
In the investment world, fear can be a constructive force, undoing the distortions and excesses wrought by that other great motivator, greed. The October plunge in global equities is a case in point. It has finally generated a significant outperformance by value stocks, those which are assigned relatively lowly valuations by the markets.
This should not be surprising. Value stocks are supposed to have a “margin of safety”, but this has not been the case in the all-weather growth market of recent years.
For example, during the sharp correction of late January / early February 2018 any outperformance by value stocks was fleeting and minimal. Growth stocks continued to power ahead through the spring and summer, even as global markets struggled to regain lost ground.
The recent value rally has run the furthest in Asia-Pacific ex-Japan. It began in mid-July and cancelled out nine months of value underperformance in the subsequent three. The main driver has been the collapse of the mega-cap “BATS” growth group — Baidu, Alibaba, Tencent and Samsung — which have led a substantial market decline.
Value rallies hard in non-Japan Asia-Pacific
Despite the power of the October value rally in ex-Japan Asia Pacific, it still constitutes a minor move in the grand scheme of things, having retraced just one-third of the value slide since mid-2014. Globally, value would have to outperform growth by 24% to return to the average relationship of the past 22 years.
What can be said is that the October correction is doing the job that the February correction failed to do — namely, reduce valuation excesses and instill caution towards the most overheated stocks. Tencent, for example, rose 150 per cent from the end of 2016 to its peak in January 2018, but it has since fallen some 40 per cent.
The single most important factor in the change in market conditions has been the rise in interest rates, starting in the US but rippling out to bond markets across the world. The microscopic — sometimes negative — level of interest rates that has prevailed for the past 10 years has distorted the valuation structure of global bourses in many ways. For example –
1. “Bond proxies” — stocks considered almost as sound as bonds due to the reliable but not fast-growing earnings of the companies — were revalued as the relevant yardsticks, government bonds, soared to unprecedented levels. Such companies can be found in utilities, foods, household goods and branded goods areas.
2. Stocks of companies with low or no earnings but scalable business models with the potential to deliver huge pay-offs have benefited from the low discount rate applied to earnings far in the future. This includes many technology and biotech groups, including the non-listed“unicorns”and their financial backers..
3. Banks and other financial groups have been hurt by the collapse in lending spreads and consequently risk-free returns and fees. Financial companies face many other headwinds, but a sustained rise in interest rates — and a steeper yield curve — would reduce the pressure on their core earnings.
For that to happen, some sort of inflation scare is probably required. The US economy has achieved the fastest rate of nominal growth in many years, but so far there has been little pick-up in inflation or inflationary expectations. In other developed countries, where the recovery is less mature, interest rates remain abnormally low and yield curves flattish.
Extrapolating from current trends, many commentators and investors have convinced themselves that inflation will stay at negligible levels for structural reasons – such as demographics, the globalization of labour, the rise of Amazon, Uber, Air B’nB and other disintermediating price-busters.
Thus, the “inflation can never happen” view has become the mother of all “this time it’s different” calls, with enormous implications for asset allocation and portfolio management if it is wrong.
Crucially, it is at odds with the political dynamic which is unfolding across much of the developed world; the rise of populism and the policies it spawns, either directly or indirectly by governments seeking to outflank it. Tariffs and quotas on traded goods, higher minimum wages, heavy deficit spending on infrastructure – most such attempts to raise the labour share of national income and reduce inequality are potentially inflationary.
This is not some far-off hypothetical scenario. In the UK, febrile political conditions could lead to a change of government sooner rather than later. Super-low interest rates and tame inflationary expectations would be unlikely to survive the elevation to prime minister of Jeremy Corbyn armed with his radically redistributionist economic agenda,
In the 1970s, many observers, including future Chairman of the Federal Reserve Alan Greenspan, believed that high-ish inflation was an inevitable result of the fiat money system. They were wrong, though it took two decades to prove it definitively.
Today many believe the opposite; that “lowflation” and “noflation” are here to stay, no matter what. It is at least worth entertaining the possibility that this time too the political cycle, after many stops and starts, may succeed in blowing conventional investment wisdom out of the water.