UK: THE EQUITY SQUEEZE. - Managers are under pressure from investors who believe that the rates of return achieved during periods of high inflation can be sustained even though the conditions that encouraged the equity cult no longer exist.

by David Smith.
Last Updated: 31 Aug 2010

Managers are under pressure from investors who believe that the rates of return achieved during periods of high inflation can be sustained even though the conditions that encouraged the equity cult no longer exist.

Let us call him John. Outwardly he is the epitome of one of a happy breed of successful, modern-day businessmen. His medium-sized manufacturing company has a good range of products, state-of-the-art plant and equipment and strategically located sites. He has re-engineered and rationalised.

He has cut his labour costs without demotivating his staff. He has kept a tight squeeze on suppliers' costs, maintained his market share at home, and is doing encouragingly well in some new export markets.

But John has a problem, and it is making him tear his hair out. His investors expect too much of him. While cash is earning 5% or 6%, and government bonds not much more, he is under pressure to produce returns for investors of 20% or more. And with intense competition in all markets holding down his prices, he does not see how, barring a miracle, he can do it.

John's problem is, in microcosm, the problem facing all businesses. The cult of the equity - built on the belief that, when all else fails, business can be relied upon to produce high returns for investors, year-in, year-out - has survived even as the conditions underlying that belief have changed. Is it now time, not to salute that cult, but to prepare ourselves for something very different - the imminent death of the equity?

There are four reasons why this may be so. Each is important, but collectively they have the potential to be devastating. First, there is the onset of a new era of very low inflation. Economists talk of the 'zero era'. Even though Britain has not quite got to that in terms of the published inflation data, this is the reality that many businesses have been facing for several years. The difficulty is that many investors suffer from the money illusion - they believe that the high (nominal) rates of return achieved during the inflationary era can be sustained beyond it, and are disappointed when this is not the case.

Second comes the loss of the inflation premium: investors may expect high returns from equities but they also recognise that one of the special attractions of buying shares - that they are an effective hedge against inflation - is lost when the inflation environment becomes benign.

Then there is the magnet of the emerging economies: while firms in Britain and most other industrialised countries face an environment of slow growth, little prospect of raising prices and limited opportunities for generating productivity growth, competitors in the industrialising countries operate in a climate of strong economic growth, low labour costs and big productivity gains. For investors in a globalised capital market, they offer the prospect of the kind of returns which are becoming difficult in Britain, albeit with a significant risk premium attached.

And finally there is the prospect of a greater worker share of the proceeds of economic growth: last year, the share of wages and salaries in Britain's national income fell to its lowest level since the figures were first calculated in the 1950s. The pendulum, however, may be about to swing back. In the US a debate is raging over the merits of downsizing, making the climate more difficult for corporate rationalisation and leading to predictions of a rise in wage and salary share there. Where America leads ...

Surely though, to take these in turn, low inflation represents the very environment which should be extremely good for business, and therefore for earnings? Not necessarily. Roger Bootle, chief economist of the HSBC Group, has become the high priest of the inflation-is-dead school. His book, The Death of lnflation, is in part an analysis of the many reasons why, in his view, we have entered an era where the threat of prolonged deflation is as big as that of a recurrence of endemic inflation, and in part an extended buy recommendation for bonds.

'The transition to very low interest rates will bring big profits to bond holders but the financial markets will be unstable and there may be financial panics prompted by high debt levels,' the book predicts.

And in this lies the danger for equities. 'By and large, the cult of the equity has coincided with the inflationary era,' Bootle says, but stops short of concluding that equities will automatically suffer in the zero era. 'My stress has been on the upside for bonds rather than the downside for equities,' he points out.

There are, however, plenty of dangers for equities in his analysis. The relationship between equities and bonds is intimately linked to the story of inflation. In the low-inflation golden age of the 1950s (when annual price rises averaged 2%-3%), the expectation was of a yield gap between equities and bonds, with investors requiring a higher return on the former to compensate for the greater risk of holding company paper, as opposed to rock-solid government bonds which were, quite literally, gilt-edged investments.

All this changed in the inflation era. Widows left with a portfolio of so-called safe government bonds soon found themselves stuck with an asset whose real value was shrinking, and which offered a lousy return. Shares, in contrast, offered an attractive hedge against inflation, their prices rising at least as fast as - and usually well ahead of - the general rate of inflation.

In this environment governments were forced to issue bonds at yields well above those available on equities to compensate for the lack of inflation protection in the underlying asset. The reverse yield gap was born. In the 25 years from 1970, which included the worst inflation episodes of the modern-day British economy, the dividend yield ratio - the ratio of bond yields to dividend yields on equities - typically fluctuated between 2 and 2.5. Equities offered a far lower yield but a much bigger total return. An investor who put £1,000 into equities in 1970 and reinvested the income would have seen its value rise to £46,157 by 1995. A similar amount invested in gilts would be worth £16,767, in cash (short-term deposit) £11,996.

The return of low inflation should mean that, even if the old yield gap does not come back, the ratio between equity and bond yields should drop significantly because the inflation penalty of holding bonds is greatly reduced, and the value of equities as an inflation hedge similarly diminished.

Bootle suggests that a more appropriate dividend yield ratio will be below 2 and, in time, perhaps 1-1.5. Thus, far from being cheap when the dividend yield ratio is 2 (today it is higher), equities are expensive.

The adjustment to the new era can clearly be achieved in one of two ways.

Bond prices can rise sharply, thus pushing down yields. Or equities can fall equally sharply, increasing their yields. A combination of the two would leave equities well below present levels.

There is a related and greater danger in Bootle's zero era analysis. This is that, rather than neatly achieving very low rates of inflation, governments will overshoot and create an environment of falling prices - deflation. Japan has come close to that condition recently.

The new era is not, of course, the same for everyone. While Britain and the other industrial countries appear locked into a climate of modest growth and subdued inflation - and the spectre of deflation - the industrialising countries, particularly those of east Asia are in an environment of rapid economic growth and rising prices. In southern China, for example, there is something like a 10:10 economy - 10% real growth, 10% inflation.

Doug McWilliams, head of the Centre for Economics and Business Research, argues that with capital relatively footloose and free to move around the global marketplace, rates of return will have to converge on the highest available worldwide. With rates of return in Asia at 30% or more, 20% in the US and 14% or 15% in most of Europe, this is a tall order. 'As far as Britain is concerned, we start from a base where our rate of return is below even some of the worst performers in Europe, so we have a lot of ground to make up,' McWilliams says. 'Some managers are aware of the fact that shareholders are putting demands on them to achieve better returns and they don't like it.'

It is a frightening thought. With the exception of Japan, rates of return on business assets have already improved in all industrial countries in the 1990s compared with the 1980s. The average real return in the US rose from 15% in 1980-89 to 20% in the 1990-95 period. To put this in perspective, a US Department of Commerce study found that US companies investing in Singapore achieved an average return of 36% a year. Meanwhile the rate of return in Europe rose from 12% to 14% between the two periods, and in Britain from 9% to 12%.

This does not mean, of course, that investment will suddenly flow out of Britain and into China, Thailand and South Korea. Equities may have lost their attractions as an inflation hedge, but UK equities plainly carry a lower risk than those on offer in the emerging markets. 'We have much better developed markets,' says McWilliams. 'Many Far Eastern firms regard outside investors as useful fools to be taken advantage of.'

Even so, the only way that profitability in Britain could reach Asian levels would be if the relative shares taken by wages and profits in the economy shifted sharply in favour of profits. But is this remotely plausible? Already, the share of wages and salaries in gross domestic product has dropped to a post-war low of 62% last year, prompting Adair Turner, the director general of the CBI, to ask whether the relative squeeze on wages has gone far enough and to suggest that, in future, employee earnings should rise at least in line with productivity.

For this suggestion, the director general was lightheartedly dubbed 'red' Adair, and the question was asked whether he had been consorting too much with the TUC.

But Turner was merely anticipating what will undoubtedly be an important area of political and business debate over the next few years, and which has its parallels in the US. When Stephen Roach, chief economist at Morgan Stanley in New York, offered his revisionist view of the merits of downsizing earlier this year, he was not the first to question whether squeezing labour costs is really a viable, long-term strategy.

'Surging profits, sustained low inflation, improved competitiveness and a record run in the stock market are all unmistakable by-products of spectacular improvements in business efficiency,' he said. 'But it is increasingly apparent to me that these are the result of plant closures, job cuts, and other forms of downsizing that are not recipes for lasting productivity improvement ...

'Some form of worker back-lash is an inevitable by-product of an era that has squeezed labour and yet rewarded shareholders beyond their wildest dreams.'

The echoes in Britain are obvious. From Labour's plans to introduce a national minimum wage, to anger over fat-cat directors and rumblings over the role of the City of London, the odds must be on a swing in the political mood that enhances the share of wages in GDP.

With stock markets in the UK and the US close to record highs, and investor interest in equities apparently undimmed, most analysts are reluctant to call a halt in the rise, and even market bears see equity prices either treading water or experiencing at most a 5%-10% downward correction. The cult of the equity still has very many subscribers. But this, to the super-bears, merely emphasises the risks. Legend has it that the US banker, J P Morgan, knew it was time to sell the market when his shoeshine boy started discussing share tips.

This is one of the signals used by Marc Faber, who runs the $30 million Iconoclastic International fund from Hong Kong. He points out also that equity investors have so far only seen the good side of low inflation because interest rates have been falling. When international interest rates rise, probably led by the US Federal Reserve Board, the correction, he suggests, could be spectacular. This is also the signal, incidentally, that Jim Slater, the controversial British stock-picker, is looking for.

Nick Knight, head of strategy at the Nomura Research Institute in London, believes that the reluctance of investors to buy in totally to the idea of a low-inflation world helps explain why, so far, equities have been buoyed up. An inflationary boom, under either a Conservative or a Labour government, hasn't been ruled out. 'One of the defining moments is ahead of us - the degree of inflation risk under a Labour government. The attitude of the UK markets would shift very sharply in favour of bonds and against equities if they felt we were permanently ensconced in a low-inflation environment,' he says.

Which brings us back to John, who is caught up in something bigger than he perhaps realised. What does he do to raise his returns on equity to meet the markets' demands? Borrow more and use less equity is one solution.

With borrowings only asking for a return of 7% or so at the moment, returns on equity can be hiked by gearing up the business - or at least by replacing shareholders' funds with debt through share buy-backs and special dividends.The trouble is, this is the very strategy that would leave John highly exposed in the event of generalised deflation - a period of falling prices which would increase the real value of such debt dramatically. The strategy is also risky if interest rates shoot up. Alternatively, John can tap into the high returns available in the rapidly-growing Asian markets. But history is littered with examples of unwise rushes into the new hot areas of the world.

Or John can sit down with his investors, explain to them that he has performed minor miracles in cutting his cost base, but patiently point out that there is a limit. He can set before them the realities of the new world of low inflation - most of them, after all, will be too young to remember a similar period in Britain's past. And he can assure them, as he sees the sceptical expressions on their faces, that he is not seeking a quiet life. Managers who pretend that it is as easy to deliver sharply rising returns in the second half of the 1990s and into the new millennium are the business equivalent of snake-oil salesmen.

One thing is clear. Many current sky-high valuations are based on assumptions about future profits growth that many managers are at a loss to see how they can deliver, even if they only care to admit it to themselves. It may be that managers are being a little too cautious. Or it may be that something else has to give, and spectacularly.

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