Stocks are risky right now — but so are all the alternatives

 

Simon Edelsten

This article was originally published in the Financial Times

The value of stocks can fall suddenly in a way that cash can’t. But introduce inflation and it’s a different equation.

Read a lot of investment commentary these days and you will quickly conclude that it is time to liquidate your portfolio and run for the hills.

It’s true that a high concentration of the global equity index is in a tiny cluster of companies whose future fortunes rely on the build-out of a technology with uncertain profitability. At the extreme sits SpaceX, with a share price that is in the region of 100 times sales, and maybe soon Anthropic, which is targeting a $2tn valuation at its upcoming IPO, while reporting revenues of just $4.59bn.

So why aren’t the sirens going off in my office even as semiconductor stocks were melting this week? Because none of the other options look much safer to me at this time.

Let’s start with cash. The nominal amount of cash I hold in the bank might look stable, but its purchasing power isn’t. Over the past five years my electricity bill has shot up by 50 per cent. If you were valuing my cash on a per kilowatt-hour basis you’d say it had dropped by a third.

And these are inflationary times. The oil price was over $107 a barrel this week and, excluding the US president, a shrinking number of people believe the Strait of Hormuz will reopen any time soon.

Meanwhile, global equities have risen more than 70 per cent over the past five years. Academic theory says that these higher returns are payment for taking higher risk.

As an equities fund manager, you might call me biased, but I’ve never found this argument fully convincing. Yes, your £1,000 invested in stocks can fall to £700 or even less quite suddenly in a way that cash can’t. But introduce inflation and these nominal amounts look very different. It might take time, but equity prices can bounce; cash doesn’t.

The companies you are investing in live in the real world and their earnings eventually offer some inflation hedge. If they’re good companies, they can raise their prices when cost pressures come and, if their margins hold up, their earnings should rise in line with inflation plus any underlying real growth in the business. That should eventually feed through to share prices.

Furthermore, a balanced portfolio of global equities has further de-risking characteristics. It can have a bias towards stocks less affected by inflation — such as unfashionable telecoms companies which raise our bills by at least inflation most years — as well as towards countries with lower inflation.

What about another comparator: government bonds? Investment lore dictates that if the returns from so-called risk-free assets go up, then that makes riskier assets such as equities less attractive and usually causes their prices to drop (they have not done so yet).

I think this theory has its limits. First, the idea that bonds are “risk-free” seems the same sophistry as the claim that cash is safe. A 30-year UK gilt issued in April 2021 at £100 trades today at £40. And don’t think “index-linked” bonds are the answer to inflation. The name is misleading. The purchase price of an “index-linked” bond always reflects the inflation expected at that time. You make money if inflation turns out higher than expected and lose if it is lower.

All western governments have got themselves into a situation where they have a shedload of debt to issue for years to come. There are some differences around the world. The US is funding tax cuts, France pensions, the UK welfare, housing, bus fares, defence, the NHS and so on.

It’s the US whose issuance problems are most pressing, as the US Treasury seems to have failed to fund itself with long-dated bonds when rates were low. The US has more than $40tn of debt, equivalent to nearly $300,000 per household. Its debt repayments have shot up 150 per cent in five years.

Of this debt, about $7.25tn is in bills that need refinancing within a year — over 22 per cent of GDP. The equivalent figures are 8 per cent for the UK, 10 per cent for France and 7 per cent for Japan.

But the US’s problem might become ours. On top of the Treasury sucking that lot out of the lending market, you have traditional companies needing to roll over their maturing bonds. Then there is the extra trillion dollars or so of funding the AI data centre builders need next year. This could drive bond yields higher still.

So how risky are stocks against that backdrop? If the bond market stumbles under the weight of US Treasury and AI issuance, the downside in equity markets could be very sharp in the short term. What has gone up a lot can go down a lot more than some expect.

But have things gone up a lot? Compared with very long-term data — such as the Schiller index — today’s valuations seem off the charts. That is because you’re measuring modern tech-heavy markets against historic ones dominated by banks and oil companies that tend to have low price-to-earnings ratios. Taking the tech stocks out of the US indices leaves the rest at reasonable valuations.

And while AI stocks often look expensive, stocks in the wider world — from the UK to Japan to China — trade on historically normal valuations.

Schneider Electric, the French electrical equipment maker, has just spent $22.6bn buying a US robotics specialist. We own the stock and think it’s a good deal; the market doesn’t. The share price is down 12 per cent in two weeks, putting the stock on 21 times next year’s earnings.

Even some AI stocks look reasonable to me. If you want a dog in the AI fight, Alibaba — the Chinese retail giant that is now the country’s largest cloud-computing business — is on a modest two times sales (though most of those sales are from online shopping rather than AI). We own shares in it.

You might also look at unfashionable hydrocarbon-producing stocks. Yes, we should concern ourselves about emissions, but we are not going to stop using gas any time soon. We own oilfield services company SLB on 12 times earnings.

Finally, mid- and small-cap shares have generally missed the technology boom. They may also be somewhat protected in these market conditions: they do not fund themselves from the bond market and their valuations are not historically stretched.

So no, I’m not putting my hill-running boots on yet.

 

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