24 JUNE 1966, Page 26


Steel and the Equity Squeeze


..ou may have been astonished at the extra- _I ordinary sight of a cheerful Stock Exchange and a painfully extended seamen's strike, but it is not as mad as you imagine. Most people seem to think that the seamen are giving the coup de grace to the Government's incomes policy and that even if a settlement is eventually reached on the basis of the Pearson report it will be grossly inflationary. What we are seeing, then, is pri- marily a herd movement into equity shares in the common belief that this gives the owner of capital some protection, however imperfect, against the continuing fall in the value of money. But there is a secondary motivation which is technical but powerful. I have often referred to the new reluctance of investors to sell equity shares—after the capital gains tax had been im- posed—and the new demand for them which had been created by the steady expansion of the unit trusts and pension funds. This tightening-up of the demand-supply situation was made much more acute by the new system of company taxa- tion. Because it benefits a company tax-wise to issue debentures and loan stock instead of equity shares. The new supply of equity shares has now shrunk from a stream to a trickle—from about £200 million a year to £451- million. Exploding into this short position comes the nationalisation of the steel industry. At one stroke of the legisla- tive pen over £400 million worth of equity shares will be taken out of private hands, paid for in government stock, turned into cash and re- invested in the relatively diminishing pool of equity shares on the market. It is enough to blow the 'blue chips' through the Stock Exchange roof.

This cannot be a pleasant prospect for Mr Callaghan. No Chancellor wants to see his government bond market watered down by the issue of stock which nobody wants. Or to en- courage an inflation-hedging movement of the herd into equities. This is the worst possible moment to call attention to the fact that in the last four years money has been depreciating at the rate of 3.7 per cent a year, measured by the index of retail prices. Professor Merrett and Mr Allen Sykes have just brought up to date their analysis of the performance of UK equities and fixed-interest securities. The following table is taken from their current article,* which gives the average yearly return in money and real terms of a lump-sum investment over different ten-year periods—the `return' being the net dividends accruing and the final capital sum realised on selling at the decade's end :

Average PA Return on Lump Sum Invested in Equities

In Money Terms In Real Terms

Over period 1929-1939 +2.9% +3.6% 1946-1956 +7.1% +2.1% 1951-1961 +13.8% +9.2% 1954-1964 +14.6% +11.3% 1956-1966 +9.2% +5.9%

Average PA Return on Lump Sum Invested in Bonds

1929-1939 +5.3% +6.1% 1946-1956 —2.8% —7.4% 1951-1961 —2.2% —62% 1954-1964 —1.1% —3.9% 1956-1966 —0.6% —3.6%

• District Bank Review, June 1966. The outcome of this kind of calculation vitally depends, as the authors point out, on the state of inflation or deflation during the year in which the investment is undertaken and the year in which the shares or bonds are sold. This a brought out in the comparison between a pre-war deflationary decade (1929-1939) and a post-war inflationary decade (1954-1964). The latter shows the post-war adjustment to what the authors de- scribe as 'a permanent state of more-or-less controlled inflation.' This has been marked by a substantial increase in equity prices and a sub. stantial fall in bond prices following the rise in interest rates. Of course, it would be rash to assume that the state of 'more-or-less controlled inflation' is , to continue permanently. If the Government's incomes policy is to break down completely because the trade unions refuse to exercise restraint during periods of full employ- ment, then a policy of stern deflation and massive unemployment might well be substituted by an exasperated labour leadership. But with the Early Warning Bill now coming forward, it is too early to say that the incomes policy is dead—after all, it is merely an attitude of mind, not a work- able control—and it would be wise to recognise the fact that this Government is really bent on killing the cult of the equity share by its new corporate taxation and its coming new relation- ship between management and shareholders under the Companies Acts.

The cult of the equity has been encouraged in the past by two trends which no longer operate —a fall in the relative weight of company taxation and a rise in the proportion of com- pany earnings distributed. In the six years ending 1965 company income rose by about 334 per cent, company taxation in the UK fell by 3 per cent and company dividends increased by about 50 per cent. According to the Financial Times index, the proportion of company earnings dis- tributed in net dividends rose from 40 per cent in 1954 to 64 per cent in 1965. Inevitably, the new system of corporation tax will cause the pro- portion of company earnings distributed-to fall. And the squeeze in profit margins will probably result in a large number of dividends being cut.

Mr Callaghan must therefore be veil, angry that this should be the moment chosen to add to the increasing stream of money chasing a diminishing supply of select equities. But this is exactly what the nationalisation of the steel in- dustry will do. It will intensify the boom in the shares of companies strong enough to hold their dividends during the profits squeeze and give the public the general impression that the City has no confidence in government bonds. its government incomes policy and in government administration of our mixed economy. This is surely counting the chickens dead before they have been hatched. There is only one way in which Mr Callaghan can avoid the unfortunate market trap which awaits him. He can cause the steel companies to issue a single special vest- ing share which gives the Treasury voting con- trol and then wait until the reconstruction of the industry has been carried through before finally taking over the frozen equities from their disgruntled private holders.