Is it time for a financial Plan B?

If economies are recovering and inflation expectations are genuinely higher, does that mean the end of the loosest period of monetary policy in history? If so, it will have large implications for markets, valuations and asset allocations.

Central banks around the world are committed to raising interest rates sooner and faster than previously anticipated to fight off stubbornly high inflation. In a double whammy, the US Federal Reserve and the Bank of England say they may need to sell bonds not buy them – quantitative tightening (QT) rather than a more gentle phasing out of QE. If central banks sell bonds, prices will be pushed down still further and yields will go up.

The market reaction has been dramatic. Higher rates and higher inflation diminish the present value of future earnings (and therefore share prices, all else being equal). The prospect of QT rather than QE, alongside strong evidence that economic recovery is holding up, have powered a rotation into more cyclical (and likely more value-oriented) areas of the market. This has been at the expense of longer-duration ‘growth’ businesses whose payoffs come much farther into the future. Investors are placing a higher value on earnings that are visible today, as opposed to the promise of something in the more distant future.

Once more unto the breach …

We’ve been down this road before, however, and growth has recovered even more strongly. But could things be different this time?

Earlier this year, I suggested that investors whose Plan A focused on holding high-growth (mainly US) tech stocks might want to consider a Plan B. If the Plan A of holding long-duration growth stocks no longer feels like a slam-dunk, I proposed that holding a bit of the less growthy and more cyclical UK market could be an attractive hedge.

There are huge pressures on UK savers right now. Interest rates may be rising, but savings accounts still offer paltry returns. At the same time, the cost of living is rising – we’re all feeling the ravages of inflation which eats away at the future spending power of the cash sitting in our bank accounts. This is what is referred to as ‘financial repression’ – the erosion of savers’ future spending power. I believe equity income is a valid solution to this problem. Attractive dividend yields, the prospect of real growth in income and capital, and a UK equity market that’s still much cheaper than many others combine to offer at least some margin of safety.

Yes, there’s a lot that could go wrong – policy mistakes by central banks, economies stalling rather than recovering and, of course, more COVID! There are certainly valid reasons to knock the value/cyclical rally. That said, the last few weeks have demonstrated that markets are changing. Perhaps the era of ‘easy money’ fuelling dynamic markets, and the even more dynamic valuations of some longer-duration growth stocks, is coming to an end?

Equity income hasn’t been an attractive proposition over the last few years. Last year was a very good one for the sector, but it possibly passed by unnoticed.

If the rotation into value/cyclicals, like the inflation that has catalysed it, proves more than transitory, we think the argument for equity income will regain some of its lustre. Throw in the potential for more economic expansion in a world grown used to living with COVID, and the ingredients are arguably there for it to look like a pretty compelling contingency plan!