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A significant change in monetary policy is under way around the world. From Abenomics in Japan, to the greater flexibility just afforded to the Bank of England with regards to pursuing its inflation target, and the Federal Reserve introducing an explicit unemployment target, it is clear that the days of inflation targeting are numbered.
The focus on lower inflation has lasted more than 30 years, resulting in three decades of falling inflation. In the US it dropped from 12 per cent in 1979 to below 2 per cent before the credit crunch hit. The policy also produced a 30-year bull market for bonds, as US Treasury yields fell from more than 15 per cent in the early 1980s to below 4 per cent by the mid-2000s.
However, this success in beating inflation has been achieved at the cost of a declining share of labour in national income.
It is not a coincidence that the share of labour in GDP peaks in the 1970s for both the US and the UK. Given that the largest element of costs was – and remains – labour, the fight against inflation amounted to a campaign to squeeze labour incomes.
The benefit to bondholders of such a policy framework has been readily apparent. Less clear, however, is the way that the anti-inflation monetary regime helped shape the corporate business models that were successful for managements and equity investors alike.
By squeezing the labour share of GDP, policy makers implicitly changed the relative cost of labour and physical capital, in part, through the persistence of high real interest rates.
With most developed economies adopting similar strategies for controlling inflation, currency volatility also fell. As a result, companies had an incentive to adopt “capital light” models using limited physical capital (preferring outsourcing) and low-cost labour.
Over the past 30 years, it has been “capital heavy” sectors such as utilities, automobiles and real estate that have been the worst performing equities. The “capital light” sectors, by contrast, with low capital expenditure relative to revenue, such as retail, healthcare and food and beverages, were among the leading sectors. Banks and insurance (service sector industries with high labour costs and low capex) were winners until the credit crunch.
While investors may have realised that a less rigid focus on inflation targeting will mean a shift in favour of equities and away from bonds, it is less clear that equity managers, or corporate managements, have realised that this change in the monetary policy framework in favour of “nominalism” will have a profound impact on the type of equities that outperform in coming years.
The current outperformance of “quality” and “cash flow rich” stocks is clearly linked to the bond-like qualities these equities have acquired. In a world where the yield on bonds was falling, managements were increasingly incentivised to run their companies for cash and deliver strong dividends.
It is tempting to think that the change in monetary policy will trigger a shift in this strategy towards lower-quality and low cash flow stocks. While this is an appealing conclusion, it may, in part be false. Quality and cash flow will probably remain crucial, but the stocks and sectors in which they are found may differ.
Back in the 1970s world of utility banking, with limited private sector cross-border financing, it was “capital heavy” areas, such as real estate, that provided a key source of wealth. Indeed, in a world of negative real interest rates, where governments are using inflation to reduce the real value of their debt (dressed as a willingness to boost employment) we should expect the “top-line” to become more important than the “bottom-line”.
In such a situation, quality will be redefined and cash flow will most likely be found in companies that have hard assets backing their activities, low direct exposure to rising labour costs, and an ability to pass through increased inflationary pressures.
As governments move to more “debtor friendly” monetary regimes, rather than the “creditor friendly” regimes of the past three decades, the corporate sector will be unable to be a simple observer. Imaginative group structures, rather than the imaginative financial engineering of the past decade, will become increasingly necessary. Investors will need to find businesses that have strong cash flows and couple them with growing, but capital consuming, businesses.
The irony is that this combination is most likely to be found in the out-of-favour basic resource stocks, rather than the consumer staples that currently dominate investor portfolios. Changing monetary regimes may mean that the “great rotation” is less about asset allocation and more about sectors.
Ian Harnett is joint managing director of Absolute Strategy Research. David Bowers, joint managing director, is the co-writer
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