The Outlook for Investment
By FRANCIS WHITMORE As every investor has been made acutely aware, great changes have been taking place in recent months in the economic and financial scene. Some had already begun before the new Government in this country introduced new policies. Interest rates had begun to harden after the long spell of ultra-cheap money, and activity in a few sections of the British economy, notably textiles, boot and shoe manufacture and one or two luxury trades had fallen away from the peak levels of the pOst-war boom.
In the stock markets a feeling of mild uncertainty found expression in the autumn of last year in an irregular course of prices. While the shares immediately affected by trade recession fell sharply, markets as a whole moved within narrow limits. There were far fewer buyers and such buying as there was had become more selective, but, there was no real pressure to sell. It was .even thought in many sections of the City that the effect of the change of Government would be so to reinforce investment confidence as to give a tonic to security prices. Many were the bold optimists who ventured to predict a substantial recovery which would extend not only to gilt- edged stocks but/to industrial ordinary shares.
HIGHER INTEREST RATES What has, happened to falsify those high hopes ? First and all- important, the new Government decided—in my view quite rightly— to use the weapon of interest rates in its plans for containing inflation and saving the pound. By raising the Bank Rate and applying other measures for making credit both scarcer and dearer the Chancellor of the Exchequer has brought us back at least some way towards financial realities. But what was not recognised as it should have been was that dearer money could not be made effective without radically altering the whole basis of stock market yields. Since last November gilt-edged prices have adjusted themselves to Mr. Butler's new struc- ture of interest rates through a fall of over 10 per cent. That in turn has meant a substantial drop in security values through the normal and inevitable process of yield adjustment. At the moment this downward movement has proceeded to the point at which British Government securities with no' definite redemption date are priced to give a return of over 4i per cent, and yields on the top-class industrial ordinary shares average a little over 6 per cent.
PROFITS SETBACK
The rise in interest rates is not, however, the whole explanation of the fall in market values. When we come to consider the sharp set- back in industrial ordinary shares and, even more, the catastrophic falls in shares in the commodity groups, such as rubber and base metal shares, by far the most important influence has ben the sudden deterioration in the profit position and prospect. Already the transition from sellers' to buyers' markets has left its mark on the profits of companies in the wool trade. The same sort of transition, indicated by the steep falls in commodity prices from last year's Peak levels, will be mirrored in this year's results of the commodity producers. So far, fortunately, on a much more modest scale keener competition and reduced profit margins are also becoming discern- ible in the financial results of a very wide range of industrial companies. Appropriately, the stock market, whose function it is to look ahead, has been adjusting its price. s to the probability, and in many instances the certainty,, of dividend cuts of varying severity. This expectation of lower earnings and reduced dividends explains the " apparent " yields (based on current dividend rates) ranging between 10 and 15 per cent. on many industrial ordinary shares, and of anything from 15 to 50 per cent. on most rubber and base metal shares.
BANK RATE OUTLOOK The question now facing the investors is : Has the fall in markets gone far enough ? The answer depends mainly on the outlook for interest rates and the prospects of trade. So far as the interest rate factor is concerned, the indications are that Mr. Butler's medicine, Which includes import cuts as well as dearer money, is beginning to work. Although wage demands still threaten the internal stability of the pound, there is evidence that the rise in the cost of living has been arrested. On the external front the alarming drain on our gold reserves has, at least temporarily, been stemmed., One is tempted to draw the comfortable conclusion that the credit squeeze has gone far enough and that perhaps not this year but probably next the Chancellor might feel justified in relaxing his grip.
This, in my' view, is an unduly optithistic hope. Welcome and encouraging as the rise in the gold reserve figures is, we must not forget that it has been due in great part to the covering of a world wide " short " position in sterling. These” " bear " positions are covered only once and, if foreign confidence in the pound should begin to waver again, they may be re-opened.
From the latest trade figures it is obvious that the external pay- ments of the U.K. have not yet been brought into balance, and the same is doubtless true of the sterling area as a whole. Imports are expanding only very slowly to the cuts, and exports, so readily saleable last year, are now running into increasing troubles. I think it premature, therefore, to assume that sterling will get out of its present difficulties without the need for a further rise in the Bank Rate, which, if it happens, will bring another setback in market values but more especially in gilt-edged.
Is it too soon, then, to consider gilt-edged investment even after the recent heavy fall ? For those who do not need income and who would be disturbed by a further decline in prices I think it is, but froth the long-term standpoint I would regard the current level as reasonably attractive. When medium-dated gilt-edged stocks can be bought to give a running yield of over 41 per cent. with £15 to L20 of tax free capital profit accruing at the end of 25 years or so the long-term buyer—and especially the surtax payer—may well feel that he cannot go far wrong.
INDUSTRIAL EQUITY SHARES What of industrial ordinary shares and the commodity share groups, whose fortunes are most closely linked with the trading outlook and the consequent prospect for profit-earning and divi- dends ? Again I feel that even after the dismaying setback of the last seven months the bottom may not have been reached, although I must point out that these sections of the market cannot all be covered by a single broad gen,eralisation. In the textile group, for example, the recession in trade began early last year and the fall in share prices has been so severe that shares in some of the best wool and • cotton companies may now be regarded as sound purchases for the long term. But taking a broad view I doubt whether one need to be in any hurry to be fully invested in equity shares, even though I am not expecting anything worse than a moderate trade recession. These are my reasons : (I) The change from sellers' to buyers' markets is still in progress and with increased competition to the export field is likely to have a severe effect on profits for at least another year ; (2) Rearmament work, although immensely important as a sustaining factor in the industrial economy, is unlikely to yield the same margin of profit as civilian work has done in the recent phase of sellers' markets ; (3) The heavy capital requirements of industry pressing on resources diminished by taxation will tend to drag down equity share prices.
U.S. BUSINESS OUTLOOK In the outlook for industrial equities as well as commodity shares the course of trade in the United States is clearly of key importance, Expert any major setback there would have severe repercussions. =pert opinion is divided, but I side with the majority view that rearmament, housing activity, and the backlog of unfilled orders held by heavy industry, together provide strong sustaining influences in America's business situation. For the speculatively-minded, therefore, I would suggest a modest proportion of base metal, prefer- ably copper and tin shares, at current prices, and of rubber shares, la,. any of which can now be bought for less than the cash and other tkluid assets held by the companies.
MERITS OF GOLD SHARES Finally, a word on gold shares. Prices in this market began to fall long, before the slide in industrial ordinary and commodity shares, and are now below the pre-devaluation levels of September, 1949. They may_ go a little lower yet if the South African political situation should get worse, but I think a level has been reached at Which a well-balanced investment portfolio should include about 10 per cent. of gold-mining shares. if by ill chance the pound develops fresh weakness and some new alignment with the dollar has to be faced, these shares provide a useful " hedge." Alter- natively, if deflation makes further progress the gold mining industry 1191 benefit from some reduction in its working costs. On the longer view there is always the possibility that if the need should arise for America to " prime the pump " she might do so by increasing the dollar price of gold.
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