For many months, Stock Markets have been led and dominated by inflationary concerns. Following the Russian invasion of Ukraine last year, commodity and energy prices rose sharply, introducing a high level of price inflation into the global system.
In many countries including the UK, a tight labour market has meant that trades unions have been able to force wages up, further entrenching that inflation. The Central Bankers handbook dictates that the response to inflation is to increase interest rates and so in the UK they have gone up from 1/4% to 5 1/4% between February 2022 and September 2023 and in the US, they have gone up from 1/4% to 5 1/2% over a similar period.
The BBC consistently report that interest rates are ‘high,’ but we regard these rates as normal. In the US rates averaged 5.43% for the period 1971 to 2023, despite the extended period of post-Covid crisis low rates.
Normal or not, money now costs to borrow in a way that it hasn’t since 2007 and capital is again being rewarded for its role as an engine of production. For company valuations, there are two significant effects:
> Firstly, as Stock Market investors rightly expect a return greater than the ‘risk free’ rate for simply leaving their capital on deposit, when that risk free rate increases as it has, shares are effectively devalued.
> Secondly, companies that are not earning high returns at present but expect to in the future – ‘growth investments’ – are devalued relative to ones that are earning more now but are not expected to see strong future growth. This effect is mathematical, as £1 of earnings in (say) 10 years’ time is worth a certain amount now but would be worth less now if inflationary expectations were higher.
This latter effect could have serious implications in America.
The US Stock Market has outperformed many such as the UK, rising 12.4% to date in 2023. However, extract the big 7 tech stocks (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta) and the rest of the US Market was up by only 0.1%.
Share prices go up for two reasons – because their earnings are growing and/or they get more expensive relative to their earnings.
These big tech stocks are growing and still have great potential, but their shares have mostly simply got more and more expensive. There are many ways of measuring this, but relative to current earnings the average share price for the big 7 tech companies means that if they distributed all their earnings as dividends (and they don’t!), it would take around 50 years before a buyer had their money back.
This compares with about 15 years for the rest of that Market.
All this doesn’t mean that technology share valuations should imminently crash and bring down the wider Market – although some commentators have postulated that. It however seems unlikely that they can continue to be the engine of growth that they have been, that they can drive up the US Stock Market in the way they have so far this year – and UK based investors might accordingly look to reduce US exposure, and in particular exposure to those 7 giants.
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Peter Land, October 2023