GMO’s Ben Inker says he wouldn’t touch U.S. small-capitalization stocks “with a 10-foot pole” – and says he sees no asset class that is attractively priced. That isn’t the way BlackRock, the world’s largest asset manager, sees things. BlackRock’s Dennis Stattman likes Japanese equities and gold and isn’t afraid of rising rates.
Inker is the head of asset allocation at the Boston-based GMO and Stattman is head of the global allocation team within the multi-asset strategies group at New York-based BlackRock. Inker manages the GMO Benchmark-Free Allocation III Fund and the Wells Fargo Absolute Return Fund. Stattman manages the BlackRock Global Allocation Fund.
At the recent Morningstar investment conference in Chicago, the two discussed their global market views in a panel session hosted by Morningstar’s Kevin McDevitt.
Let’s look at what each had to say about key asset classes in the global markets.
On European value stocks
Although Inker sees opportunity in European value stocks, he says that “you've really got to hold your nose to find stuff to buy.” He is finding pockets of opportunity in the more cyclical, leveraged and European-focused companies – but those companies are cheap for a reason and “they all have hair on them.” He is betting that the market is under pricing unfavorable European utility, telecommunications, automobile, and energy companies. Inker said GMO has very few investments in European banks because of little visibility as to what is on their balance sheets. He is not confident that they are a bad investment but is unwilling to invest in companies he does not know much about.
Stattman sees occasional opportunity in international oil companies domiciled in Europe and in European cyclicals that offer a combination of depressed margins and cheap valuations. His optimism is tempered by underlying problems of European governments that “promise too much, tax too little and don’t have a match between their fiscal policies and monetary policy controlled by the European Central Bank (ECB).” The ECB’s guarantee of liquidity has removed the market’s fear of a European banking system failure, according to Stattman, and removal of this tail risk has led to upward valuations in European stock markets and more favorable value.
Stattman says trading equity volatility has become too crowded with the VIX, a measure of volatility, at historic lows. But Inker says that in 4% of their portfolio, GMO is selling puts in Europe and Japan where implied volatilities are higher. He sees this as a way to get paid for taking equity risk.
On U.S. small caps
With regard to U.S. small caps, Inker says he cannot envision a scenario where they can increase their profitability on a sustainable basis to justify their valuations. Profit margins have been better in the U.S. markets than in the global markets, and small caps have benefitted from their more domestic orientation and better profit margins.
Stattman also says profit margins on U.S. small caps will not continue to increase and sees those margins reverting to the mean. He is not sure when this would happen. He feels that “the labor share is an important component, and you have to be a bull on labor to be a bear on profits.”
On emerging markets and Japan
Inker says he is most scared of emerging-market countries that are in a dangerous area of the credit cycle and potentially on the edge of a financial crisis (which, he added, they deserve). In China, Turkey and Brazil, there has been rapid credit growth and investment in bad ideas. He believes those debts will go bad and negatively affect these economies.
Stattman is most bullish on the Japanese stock market, where he believes there is a lot to like. The Japanese equity market is unmatched in today’s financial markets in terms of opportunity, according to Stattman. He said Japan offers value with supportive monetary policy and the possibility of structural reform. With an economy that is 40% of the size of the U.S. economy, the Bank of Japan (BOJ) is doing its own quantitative easing and buying back $70 billion of yen per month. This is equivalent to the U.S. Federal Reserve buying back $180 billion per month. The U.S. Federal Reserve is currently buying back bonds at a rate of $55 billion per month. Furthermore, Stattman said the BOJ has told BlackRock that it will continue its QE for two years after the U.S. Fed stops.
Japan is in the early stages of a multiyear bull market, Stattman said, with corporations using conservative accounting and acting in shareholder-friendly ways. Furthermore, there are few behavioral biases in the valuations, as there is widespread skepticism of the upside for the Japanese markets and low ownership of Japanese equities by Japanese households. Stattman closed his endorsement by offering that the Japanese stock market is currently selling at a discount to the U.S. market. This is rare. The TOPIX is worth 13.6 times earnings, 1.2 on a price-to-book basis and selling at a third of what the S&P does on a price-to-sales basis. The S&P 500, meanwhile, is worth 16.3 times earnings and at 2.7 on a price-to-book basis.
In response to a question about the margin of safety in the Japanese markets, Stattman said that the Japanese markets are held to higher standards than the U.S. markets. Stattman questions, “If I’m starting at the valuation discounts that I described, why does the case for Japan have to be impeccably better in every respect than the case for the [U.S.] market that sells at much higher valuation levels?”
Inker identified many caveats in emerging-market investments. For example, Russian energy stocks appear attractive because they are trading at four times earnings, but he cautions that they should trade at this discount because these companies are state-owned and the cash flows are not fully distributed to investors. Furthermore, these companies need enormous capital expenditures to find new sources of oil which they are not finding. Inker concludes, “The true replacement cost of the oil that they’ve been pumping is much higher than the implicit cost in their depreciation, so they aren’t as cheap as they look.” Factoring in these considerations, the price-to-earnings ratios are not as low as they appear to be, he said.
On interest rates, bonds and market liquidity
Inker is not panicked that U.S. interest rates will rise in 2015 or 2016, and he believes a rate increase is priced into the markets. Interest rates can increase “without freaking out the market,” he said. Inker said he is uncertain, however, how much effect QE is having on keeping rates low.
Inker worries about corporate credit due to the Dodd-Frank Act, which changes the ownership structure for dealers who own those bonds. It is not clear to him that the liquidity is going to be there when investors need it in this environment.
Stattman agreed with Inker that liquidity has changed due to both monetary policy and the regulatory environment. Stattman said: “Bond markets that used to be 25 million bonds bid, 25 million bonds offered, are now 2.5 million bid or offered, or maybe 1 million bid or offered.” Stattman said that it is a “different world than it used to be.”
We are in the late stages of low interest rates and the depressed-real-rate environment, as inflation is rising, according to Stattman. He is most concerned with the effects of rising rates on the longer-term areas of the bond market. Because spreads on low investment grade and high yield bonds are at 10-year lows, his firm is avoiding this credit risk.
Inker is not increasing the duration of his fixed-income holdings. He said GMO is moving away from cash and its negative annual real return. His challenge is to find something better than cash without taking much risk. He said the most attractive part of the yield curve is in the five- to seven-year range for Treasury bonds, “where the market is pricing in sort of a full normalization of interest rates” and yields are being pushed a little bit by inflation.
With regard to European fixed income, Inker is very surprised that investors are lining up to buy Greek debt after two recent Greek defaults. Greece has an unsustainable debt-to-GDP ratio, he said, and he is concerned that investors are making the bet that the ECB will come to the rescue should Greece sustain further economic problems.
Stattman’s message on fixed income is to be careful, as investors can lose more in bonds than they realize. He currently likes Brazilian local-currency debt with yields of 10-12% and real yields at 4-6% and has a small position in these securities. As of March 1, Stattman held 18% of his portfolio in cash to keep the duration of his fixed-income portfolio low and to keep the overall beta of the portfolio where he wants it relative to its benchmark and the S&P 500.
With CPI inflation up 2% in the last year, Stattman sees labor costs as his “dark horse candidate” for continued inflation. “We have a bifurcated market for labor in America,” he said, with a high demand for skilled and educated workers. The low-interest-rate environment has stimulated this demand, and corporations cannot attract enough skilled workers. In contrast, Stattman does not see any interest rate that is going to stimulate the demand for low-skilled blue-collar workers.
In today’s low-inflation environment, Stattman likes the equity market better than Treasury inflation-protected securities (TIPS) to protect against inflation. A few years back, his firm held as much as 12% of its portfolio in TIPS, but it currently holds none. Despite better pricing than a year ago, Stattman sees TIPS’ yields as too low.
In contrast, Inker said TIPS looked better than cash once they “perked up to the 40-basis-point level.” He considers TIPS as a cash-like, low-duration asset, but he has moved from a 15% to 5% allocation in recent months as TIPS rates have gone down.
Stattman has been a profit taker in gold and has scaled back his firm’s precious metal allocations from 6% to 1% in the last two years. He sees rising interest rates on the horizon as motivation to pare gold allocations. But he said gold offers a hedge against unsustainable social contracts in the developed world. “How are we going to pay for Social Security, Medicare, Medicaid and interest in the United States, to say nothing of Europe or Japan?” Governments’ unwillingness to reach a sustainable fiscal policy is a reason to have a little bit of gold in the portfolio, according to Stattman.
Justin Kermond is the vice president of business development for Advisor Perspectives.
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