If you have been watching the art market closely, you might not have been altogether surprised by this week’s financial markets carnage – nor by the fact that it was led by the tech sector.
An auction at Sotheby’s last week offered a little warning to those paying attention. On offer was a framed copy of Banksy’s “Girl With Balloon”. The hammer came down at £860,000 ($1.4m) and the work instantly began to self-destruct (there was a shredder hidden in the frame). Somebody’s brand new status symbol was ripped to bits.
Most of us might have then considered the remains of the art work to be instantly worth rather less. Not so your average art expert. They instantly announced that, what with its new role as not just a piece of art but a piece of performance art – and surely the most expensive piece of performance art ever – the shredded print was in fact worth rather more.
“When Banksy does something crazy”, said one expert, “it will naturally have a dramatic effect on values.” You can interpret this incident however you like, this particular freedom being, I believe, the precise point of contemporary art. But here is one way to look at it: artists and auction houses are pretty clever; they have both picked up that something is changing in the financial world – and that this change is not going to be particularly supportive of a business model that thrives on flogging feel-good assets with no yield to the mostly undeserving rich. Keeping attention held and values up therefore requires a little more effort than usual. Look at it like this and this PR stunt should be seen as just that – the last gasp of a fairly desperate canary.
So what is this change, and what does it have to do with tech stocks?
It’s all about the rising bond yields
It has been obvious for some time that 2018 would be the year inflation began to build in the system and interest rates would turn. You can argue about why this is the case and whether it will last or not, but you can’t deny that it is happening.
For 30-odd years, yields around the world have been falling (you have been getting less for lending your money to governments) into an environment of falling inflation numbers. They aren’t falling any more.
The yield on US ten-year Treasury bonds jumped to 3.26% on Tuesday. It wasn’t much above 2% at the turn of the year. This matters, because the yield on government bonds is the cornerstone of all equity valuation models and the bar by which we all – consciously or subconsciously – judge the risk inherent in our investments.
If you can get nothing – or only a negative return after inflation – on a government bond or in a deposit account (3.2% is a distant dream for Europeans) it doesn’t seem silly or even madly risky to invest in other assets that pay nothing. This applies to works of art in suspiciously heavy frames, or technology stocks that promise a networked monopoly of endless profits – but maybe not for 20 years.
When there is no return on cash, lots of cash at some indeterminate point in the future can look a lot more attractive than a little of it now. But while you can justify any old expensive growth story when rates are very low, you can’t do that when they aren’t.
As interest rates rise, investors begin to express a preference for the jam they know they can get today, rather than that which is promised several tomorrows from now. That’s why they might not be rushing to buy Banksys for much longer, and why tech stocks have been so badly hit in the global markets sell-off this week.
Anyone holding shares in so-called Faang stocks (Facebook, Apple, Amazon, Netflix and Google) will know what I mean, but the shift is best summed up for many readers by the performance of shares in Scottish Mortgage, an investment trust that many investors – including me – hold to gain exposure to high-growth stocks. They are down about 10% since the beginning of October.
It seems, as Capital Economics politely puts it, that “investors are still struggling to assess appropriate valuation multiples in an era of higher interest rates”. Clue for those still struggling – assess them lower.
There are other things in the mix, of course. October is traditionally the month when the market takes money off the table. The stand-off between Italy and the European Union is fascinating (who rules Italy – Italy or the EU?) but it is unlikely to be resolved in a hurry and anti-EU feeling is high in Italy.
The midterm elections in the US are another worry. Republican success would give more power to Donald Trump, which could be scary. Democrat success could mean a potential impeachment, which is also scary. But scariest of all is that US federal debt, now at more than 100% of GDP, is back in the news.
These worries are playing out against a backdrop of trade tensions – the globalisation that has been so very helpful to big listed companies over the past decade is, at best, stalled.
All of these things matter. But the thing that matters most is bond yields. While they have been falling, valuations haven’t mattered. Now they aren’t, they do.
How to invest in a world of higher bond yields
So how do you invest in this environment? The key, of course, is to keep out of things at risk of being shredded after you have paid for them.
So you keep a bit more cash than usual in recognition of its optionality. If the rout continues, real bargains will appear and only those with cash will get to buy into them. And you recognise that what you are seeing here is as much a great rotation as a market correction.
So you rebalance out of growth stocks – which we can loosely define as those promising you cash flow and profits some time in the future – and in particular technology stocks (usually the growth stocks with the longest-term promises). The obvious alternative is to move into value stocks – those offering you cash flow, profit and dividends now.
Regular readers of this column won’t be much surprised by what is going on in the market. Look back at the value funds I have mentioned in recent columns – I hold both the Personal Assets Trust and the Ruffer Investment Company – and perhaps go back to some of the multi-asset funds that did so well for investors the last time markets corrected. We haven’t heard much about these kinds of investments recently. But perhaps we soon will.
• This article was first published in the Financial Times