The investment prospect MONEY
NICHOLAS DAVENPORT
On this long weekend it behoves all good investors to re-examine their position in the stock markets. They have fared far better than they could have imagined six months ago. To begin with, the gilt-edged market has en- joyed a real boom. Since September last year the long-term rate of interest has fallen from about 7+ per cent to 6.45 per cent, which has caused War Loan to rise from 47+ to 55. (Some lax-free zone' stocks have risen by more than 15 per cent.) Next, equity shares, after falling 23 per cent, have recovered half their decline, the Financial Times index of industrial shares regaining forty-five points—from 284 to 329.
No doubt a few investors will now be think- ing, it prudent not to tempt providence any further but withdraw from the market altogether and seek the spring sunshine in Malta (where the natives are specially pleased to see British tourists as long as they are not related to members of the Government). Some are even bearish enough to say that equity shares will not be profitable again while Labour rules at Westminster. Nevertheless, there are still some bullish voices to be heard, arguing that it would be foolish to leave the market at the present time if the economy is on the eve of some reflation. I propose to examine this argument first.
The bullish case is twofold. In the first place it is contended that there is more to go for in the gilt-edged market. As one firm of brokers put it: `For the rest of the year the £ should be out of trouble. The balance of payments will be in good surplus and it seems likely that most of the speculative positions will be closed as devaluation fears recede.' Certainly Mr Callaghan has had a great suc- cess in getting the 'Basle' credits of the central banks renewed (£357 million) together with the small credit from France. And having re- paid the Federal Reserve bank some £250 mil- lion worth of dollars in the last two months, the special American currency 'swap' (up to $1,350 million) is still available.
There is obviously something in the bullish argument that if the gilt-edged market has no reason to worry about sterling in the short term it can exploit the downward trend of interest rates visible at home and abroad.
After the cut in our Bank rate to 6 per cent and the fall in the Treasury bill rate to 5.65
per cent the level of interest rates in the tnc is still higher than in most industrial countries. Hence the 'pull' which London still enjoys
in the 'hot money' game. Bank rate is only 3i per cent in France, Italy and Switzerland, 4 per cent in West Germany and 41 per cent in Holland and the us. Seeing that the Federal Reserve Board increased the money supply of their commercial banks at the first hint of an industrial recession there is good reason to believe that the American bank rate may come down before long to 4 per cent. So there is some point in the bullish argument that speculative investors in the gilt-edged mar- ket still have something to go for. They can, indeed, look forward to a gradual rise in the 'long' end of the market which might bring the rate of interest down to 5+ per cent, In other words, War Loan could rise six points to 61.
The second part of the bullish argument is much harder to swallow. It is based on the assumption that the budget is bound to start the process of reflation, that the economy reached bottom in the last quarter of 1966 and is now turning up and that there is there- fore no reason to expect equity shares with an average yield of 5.8 per cent at current prices to slump again below the low level of November 1966. But this makes the mistake of supposing that reflation under a Labour government is the same as reflation under a Tory government, which is nonsense. Prices and incomes are now under 'severe restraint,' and there is no doubt that the Government will be bound to restrict dividends after July if it is going to restrict the rise in wages. The 'bulls' will reply that dividends are not likely to rise in any case, but have they considered the possibility of further cuts in dividends? As the Bank of England pointed out in its recent Bulletin, dividend payments have risen sharply in recent years—in anticipation of the change in company taxation—and in 1959-65 took 24 per cent of the funds available from internal sources against 18 per cent previously.
To quote the Bank : 'The introduction of corporation tax, which favours the retention of profits and the issue of loan capital rather than equities may well encourage a return to- wards the previous pattern of dividend pay- ments.' It certainly will when directors find that company profitability was declining even before Labour took office and will decline more sharply thereafter. At the recent conference of the British Institute of Management Mr Robert Appleby, chairman of Black and Decker, showed that from 1954 to 1964 the return on total company assets in manufactur- ing and distribution fell from 12.3 per cent to 9.7 per cent and on fixed assets from 31.5 per cent to 20.2 per cent. (In America the re- turns were over a third higher.) This fall in profitability cut into what he called 'revenue investment,' that is, into the measures required to improve management efficiency and tech- nology which are financed out of revenue. This could explain the fact that although the capital expenditures of quoted companies in this decade increased by 161 per cent net profits increased by only 67 per cent. Since Labour assumed power wages have risen more sharply and profit margins have declined.
To make matters worse company investment, which might improve profit margins, is now down by about 15 per cent. Where, then, is the attraction in equity shares if the total re- turn on company assets is only 10 per cent, which, after corporation tax, becomes 6 per cent? With debenture and loan issues costing over 71 per cent new capital investment can- not pay—certainly not pay equity dividends.
The 15 per cent rise in equity share prices since November 1966 is therefore quite irra- tional, but is explainable on technical grounds of market demand and supply. Sooner or later the conventional cult of the equity will be found to be a dangerous piece of nonsense under a Labour regime which has not yet discovered how to run a mixed economy. Of course, when the present Cabinet has been persuaded by Mr Lever to restore profitability to the private sector it will be another matter.
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