Mon, 16 Mar 2015
U.S. stocks, particularly small caps, and bonds look unattractive overall, but low-double-digit nominal returns are possible for emerging-markets value stocks, says GMO's Ben Inker.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Should investors temper their expectations for future stock and bond returns? At the Morningstar Institutional Conference, I interviewed GMO's Ben Inker about his firm's asset-class-return forecasts.
Ben, thank you so much for being here.
Ben Inker: Thanks for having me.
Benz: GMO puts out a seven-year asset-class forecast. You shared some of the most recent numbers, and frankly they were a little bit sobering; but let's start with U.S. equity today. Generally speaking, it's not a particularly optimistic picture for U.S. equity.
Inker: We don't much like U.S. stocks today, and that's because their valuations are trading at the very high end of what we've seen historically. U.S. large-cap stocks don't look as expensive as they did in 2000, but we're trading at valuations today that are higher than we saw at the market peak in 1929 or 1965. We are trading at what we think of as upper 20s in terms of normalized earnings, which is really quite expensive. If valuations are going to come back to long-term averages--which is, let's say, 16 or 17 times normalized earnings--that means, over the next seven years, you're unlikely to make money relative to inflation in U.S. stocks. So, we really don't much like them. They have been worse, but they've spent most of their history much better.
Benz: Are small caps particularly unattractive to you today?
Inker: Yeah, it's one of the interesting things. Most of the times in history when the S&P 500 has been at its most expensive, it's been a large-cap phenomenon. 2000 was an extreme example of that. It was only a handful of stocks that were driving the very high valuations in the S&P 500, and so if you just looked at the average stock in the U.S., it was much less bad.
Today, we actually see something of the reverse. U.S. stocks look expensive to us, more or less across the board. But if forced to own U.S. stocks, we'd rather own the big ones. Smaller-cap stocks are trading at higher valuations than we've really ever seen. Again, they're not as silly as the Internet stocks were in 2000, but we've seen a period of time where the U.S. economy has been outgrowing the rest of the world by a significant margin. U.S. small caps tend to be much more domestically focused. They tend to be more leveraged than large-cap names, and they've been big beneficiaries of very low interest rates. A lot of things have gone their way. We don't think that things will continually go their way. And they're priced as if small caps are growth stocks, and the reality is that the vast majority of small caps are not growth.
Benz: Again, U.S. stocks are not attractive overall to you; but when you take a few different cuts of the U.S. market, a couple pieces look slightly better. Quality looks better to you. Let's talk about how you define quality.
Inker: For us, quality stocks are companies that have shown an ability to earn a high return on capital across the economic cycle, where that return on capital has been stable, and where the company has been able to do that with low debt. Those are the three key factors for us for quality. Now, those companies have some nice characteristics. They are much less likely to go bust than the average company because they are profitable and they don't have debt. They don't outperform in the long run; there is no particular reason why they should. They are probably less risky; but today, in one of the few times in history, they're not trading at a premium. These guys are actually trading at slightly lower P/Es than the average stock, which is interesting because we think they deserve a premium. And particularly today, we think they would deserve a premium because when we look at U.S. stocks today, the most striking thing is that U.S. corporations have almost never been more profitable. Profits, as a percent of GDP, are near all-time highs. Returns on invested capital look very good. We think they are going to come down, and they are going to come down more for the leveraged companies, for the cyclical companies. They are going to come down for the quality guys, but much less. So, today is a time when we think, on a P/E basis, they should be trading at a premium because their earnings are less at risk, but they are actually trading at parity or a slight discount.
Benz: International is maybe a slightly more optimistic picture. Let's start by talking about [your outlook on] developed foreign stocks and also developing markets.
Inker: Non-U.S. stocks look better than U.S. stocks; that's about the strongest thing I can say for them. They look to be the place to be. Unfortunately, even there, they've done very well since the market bottomed in 2009, and the P/Es are pretty high. If you look at Europe today, it's trading around 20 times earnings. The good news relative to the U.S. is that at least their earnings today aren't near the peak. Because the economy hasn't been that strong, profit margins look kind of normal. And so, we don't think that these markets are cheap, but we do think that they are priced to deliver returns above inflation. Whereas, in the U.S., I was talking about how the leveraged companies and the cyclical companies have really benefited from widening profit margins, that has not been true at all in a place like Europe.
What we find is, in Europe, we'd much rather buy the traditional value-type companies--the dopey companies that, in general, have some problems to them. They are trading at pretty good discounts, wider than normal. As a result, we think if you're going to be in Europe, we think you want to be in the value stocks.
Benz: How about developing value? I saw on your slide that that was about the most attractive pocket of the entire market universe today.
Inker: It's really interesting how investor attitudes toward emerging markets have changed over the past few years. Going into the financial crisis--and even a couple of years out of the financial crisis--the assumption was that emerging-markets economies grow much faster than the developed world. This is the place to be. If you're going to invest in stocks, you are a growth investor. And if you are going to be a growth investor, invest where the growth is.
People were very excited about them. The valuations rose accordingly. But the last three or four years, people have been pretty disappointed with what's happened in emerging, and the valuations have really come down. We are generally contrarians: Our view is that whatever is going on will probably cease and the future will look more normal. And if we got a return to normalcy in emerging markets, it would actually be a pretty good thing. In particular, for some of the value stocks within emerging--which have seen their profit margins come in in the past two years--we think there's the potential for P/Es to expand and, in some cases, for profitability to improve. So, it's one area where we actually think achieving low-double-digit nominal returns is possible.
Benz: Let's talk about fixed income, starting with U.S. fixed income.
Inker: The one thing that's very clear about U.S. fixed income is you're not going to get rich off of it. The U.S. 10-year Treasury bond yield is about 2%. If you buy it and hold it for 10 years, you're going get to 2%. The question is how bad is 2% going to look. [One of] the two important variables there is what inflation is going to be. Our best guess is that we're not in a deflationary spiral in the U.S. Inflation has been running positive. We've got a bit of a blip here because of falling energy prices, but energy prices are not going to fall forever. And our best guess is they gradually rise from here.
So, we think inflation is going to be pretty normal. And if that's true--if inflation is 2% and the bond yield is 2%--you're not going to make anything after inflation. So, it's hard to be excited about that.
Benz: Given that inflation forecast, where do you think TIPS are? Do you think TIPS are relatively attractive or not so much?
Inker: TIPS are OK. The question is how much do TIPS really have to yield above inflation? To be excited about TIPS today, you have to believe that bond yields over the next 10 years are going to stay low. If that's true, TIPS are the best place in the U.S. market.
A couple of things to be cautious about with TIPS: One is they are much, much less liquid than traditional U.S. government bonds. And that means that if we got another financial crisis, you could easily see what happened in the last one, which is that when you were expecting your bonds to do very well and bond yields to fall, you could actually see the bond yields rise, because you're going to have some people who are forced sellers of this stuff and nobody to buy on the other side. So, their fundamental cash flows are fixed and very low risk, but their price action might not be exactly what you were expecting and hoping from your bond portfolio.
Benz: We certainly saw that in the last financial crisis. Let's talk about international fixed income, developed-markets fixed income--specifically the hedged type of exposure that a lot of investors have in their portfolios. You think that that's a potential trouble spot and an area to be careful about.
Inker: We can't see any reason why an investor would want to be investing in eurozone bonds, in Japanese bonds, or U.K. bonds. The vast majority of what's going on in the rest of the developed world is that the yields are incredibly low. The 10-year bond yield in the U.S. is 2%; the 10-year bond yield in Germany is 35 basis points; the 10-year bond yield in Japan is 37 basis points. There is no way to get a strong return out of a 10-year bond yielding 35 basis points.
There are some people who are forced to own those bonds. If you're not forced to own those bonds--and basically no U.S. investor is forced on them--then don't. We feel really quite strongly that these are some of the worst investments in the world right now from a risk/reward trade-off. The best you can hope for is that you get to keep your 35 basis points, and the downside is quite considerable. Particularly, we think in Europe, where if the economy is bad enough that a 35-basis-point yield on a bond makes sense, we think political instability is a real possibility, and who knows what happens under those circumstances. So, perhaps our strongest recommendation today is don't own that stuff. It can't do you any good, and it could do you significant harm.
Benz: Emerging-markets bonds are kind of a different story; yields have popped up pretty nicely over the past several months.
Inker: Yes, they have. Some of that is because some of these countries are in the deep problems. If you look at a country like Venezuela, which is very reliant on energy exports for its revenue, energy prices have just fallen by 50%. Their economy doesn't work at these levels, and people are pricing in a very significant probability of default. It's a reasonably likely outcome. The good news about the emerging world, though, is that while there are some Venezuelas out there where falling prices of oil are a really bad thing, there are Indias out there, too, where the falling price of oil is actually quite a good thing.
What we've seen is it's not just that Venezuelan spreads have widened, it's that everybody's spreads have, in general, widened. We think that you are getting paid nicely for taking the risk in emerging debt. That's most obviously true in hard currency--dollar-denominated debt--although the local debt looks OK today as well. We think the currencies, in general, have gotten hit pretty hard and might be cheap.
The problem with the local bonds is--just as I was talking about in the case of European bonds--there are some entities that are forced to own these things and, therefore, the yields can move to non-economic places. You see a lot of that in the emerging world where, in the local bond market, you have people who are more or less forced to own this stuff and, as a result, yields can be lower than they would otherwise be in a competitive situation.
Benz: Let's talk about cash, finally. I noticed on your slide that the cash return over the next seven years that you're forecasting is actually better than the return on most of the fixed-income asset classes. Let's talk about that.
Inker: So, the key assumption there is that, seven years from now, things will be normal. And we define normal for cash as yielding about 1% or 1.5% more than inflation. We are obviously earning nothing today. But if we gradually see an increase to those kinds of levels, which are the kinds of levels that are also built in to the Federal Reserve's so-called "dots" about where Federal Reserve governors are suggesting things will go, you're not going to make much money after inflation. You're probably going to lose a little bit because we are starting off below inflation. But it's not going to be a disaster--and some of these bond markets are going to be a disaster. The interesting thing is that the market right now actually has a disagreement with the Federal Reserve. The Federal Reserve says cash rates are going to go back up to 3.5%. The market is saying, "We don't believe that--we think cash rates are only going to go up to 2%, maybe 2.5%."
If the market is right, cash is worse than we think and bonds are a little bit better. But it is interesting the way the market has chosen to pick a fight with the Fed on something where the Fed gets to decide what the answer is. So, it will be interesting to see how that evolves.
Benz: Ben, thank you. It's a sobering outlook, but we always appreciate hearing your insights.
Inker: Thank you.
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