What Does Ben Inker Think About U.S. Dominance in Equities?

On this episode of The Long View, GMO’s head of asset allocation, Ben Inker, discusses cheap opportunities in today’s market, explains why he’s excited about value stocks, and talks about GMO’s new quality ETF.

Here are a few excerpts from Inker’s conversation with Morningstar’s Christine Benz and Dan Lefkovitz.

‘The Magnificent Seven’

Lefkovitz: Ben, before we get to your current outlook, I wanted to reflect a little bit on the past few years. You previously appeared on The Long View in mid-2020, so the midst of the pandemic. I went back and listened to that episode and there were some areas where you were very prescient. You were negative on bonds, which contributed to a bearish outlook for the U.S. 60/40 portfolio. And of course, we had the worst bond market ever since then and a bear market for equities as well in 2022 in the U.S. But on the flip side, you had a lot of conviction at that time in equities outside of the U.S., including emerging markets. What do you think accounts for the U.S.’s continued dominance from an equity market perspective?

Inker: There are a few things. A couple of them, I think, are more likely to be temporary than permanent. Since the middle of 2020, a couple of things have happened. One is the U.S. dollar has been particularly strong and the U.S. dollar today looks pretty overvalued, which is a problem for U.S. domiciled companies relative to non-U.S. companies on a forward-looking basis. But over this period, the fact that the dollar has been strong has been kind of a headwind for U.S. dollar returns for non-U.S. equities. Another thing that has happened is in most of the rest of the world, valuations are down substantially from where they were in 2020, and in the U.S., they’re not. So, the U.S. has moved to a bigger premium on average than it was trading at versus the rest of the world since 2020.

But the other thing that’s harder to deal with and harder to know exactly what to do about is there are a handful of giant companies in the U.S.—the “Magnificent Seven” gets talked about a lot these days—that have fundamentally done really well. Now, they’ve also gotten more expensive. But on a fundamental basis, they have done quite well. They are a really big piece of the U.S. market. The S&P 500 has outperformed the rest of the world; the S&P 493 has not. And a problem when you are trying to forecast markets is the more concentrated they get, the tougher it is to make the simplifying assumptions that you can make about a more diversified index. And the Magnificent Seven have certainly done better relative to all other companies around the world than we would have guessed. It doesn’t mean they will continue to forever. But in this period, they were the thing to own.

GMO & ETFs

Benz: I wanted to ask about other geographies outside the U.S. Does quality work equally well outside the U.S.? And should we expect to see more ETFs from GMO focused on quality in other markets?

Inker: For us, launching an ETF part of it was about the strategy and part of it was about where the demand was. And ETFs are a much bigger deal for U.S.-based investors given the unique tax advantages they have for U.S.-based investors. And U.S.-based investors really like U.S. domiciled stocks. So, this was an obvious first ETF for us. It’s also one where because it’s not that high a turnover strategy, it is something that we can do actively that can be really pretty tax-efficient.

In terms of the next ETF, some of that is going to be driven by other strategies we run. But it’s also going to be driven by where do we think U.S. domiciled investors are likely to be interested. And I don’t know whether a non-U.S. quality strategy is going to capture the fancy of U.S.-based investors. It should. Quality has outperformed broadly across markets and across time. And there are certainly high-quality non-U.S. stocks.

I will say it is an interesting thing and I get accused of saying only negative things about U.S. stocks. But if you look across the global stock universe and you were to just pick, regardless of domicile, which are the very highest-quality companies around the world, a disproportionate share of them are U.S.-based. And so, the U.S. is a place where you can run a high-quality strategy and really not have to compromise much on truly buying very high-quality companies. In some other geographies, it’s a little bit dicier. You can always define the highest-quality 25% of, let’s say, the emerging-markets universe. But some of those companies will not be as high-quality as you could get in a high-quality U.S. portfolio.

Value Equities Versus Growth

Lefkovitz: I wanted to ask you about your conviction in value equities over growth. You call the current outlook for value equities exceptionally good. It seems maybe at odds with your preference for quality.

Inker: Well, the thing about value is, if you look at the way it generates returns, the bulk of the returns you get in investing in value come from the value stocks you buy that cease to be value stocks. So, it is the companies that graduate from the value universe to the growth universe that are the real drivers of returns. You can get pretty good returns from companies that stay cheap and compound nicely, but, on average, value companies undergrow. That’s not a surprise. After all, on average, growth companies outgrow. And it’s this term we refer to as “rebalancing” that is the single biggest driver of returns for value. Rebalancing is driven by two things. One is, how many of the value stocks move to the growth universe and how many of the growth stocks move into the value universe. And two, how big a return, either positive or negative, is associated with moving from value to growth or growth to value.

The reason why we’re so excited about value stocks right now is because they are trading at such a big discount to growth stocks that when a value stock upwardly surprises and graduates to the growth universe, it gets a huge return premium. And when a growth stock disappoints, becomes a growth trap and falls into the value universe. Because of the big premium growth stocks are trading at, that is a strong negative return. And so, when value stocks are trading at a much bigger discount than normal, we get excited because that rebalancing is going to be bigger than normal. And looked at on average across stocks, it’s actually worked out pretty well this year.

The outperformance of growth, again, has been truly dominated by a handful of companies. So, if we look across the median company, that positive rebalancing for value and the negative one for growth stocks on an equally weighted basis has been a big deal this year. And so, value, one, has worked pretty well outside of the U.S. this year. And even within the U.S., hasn’t been anywhere near as much of a disaster if you weren’t cap weighting. So, this year, I have been surprised by how well growth has done. I think in the longer run, these growth traps are going to be a problem for growth. But we’re still seeing under the surface, even in a very good year for growth, that that rebalancing is operating the way we would expect it to and is a really big positive for value stocks.