Indians investing in US equities should avoid bubbles, fads: Rob Arnott

"I wish fiscal and monetary "stimulus" weren't called "stimulus". It doesn't stimulate anything; it transfers wealth from future spending to today," says Arnott

Market rallies around the world are divorced from economic reality, says Rob Arnott, partner, Chairman of the Board of Research Affiliates. Arnott, who spoke recently at CFA Society India's 5th India Wealth Management Conference, tells Business Standard that several tech stocks in the US are trading at valuations as rich as the peak of the tech bubble and that nearly $2 trillion of the $3 trillion Fed stimulus may have been wasted. Arnott is bullish on emerging market stocks and bonds which, he says, are currently "unloved". Edited excerpts:

Q. Technology stocks have led the market rally in the US amid the pandemic. Apple now commands a $2 trillion valuation. Do you see a bubble building up in the space? How acute is the problem of polarisation for US equities, especially considering the deluge of passive money flowing into these stocks?

FANMAG-like stocks are in a clear bubble. Many trades at valuations as rich as the peak of the tech bubble, and require implausible future success to justify current prices. We’re also seeing an enormous surge in retail money, chasing the market darlings.

Speculation in bubbles can still be profitable, because bubbles can keep going far longer and much higher than any sceptic might reasonably expect; but this only works if you have a sell discipline. If you don’t know why, when or at what level you plan to sell, you will lose to someone who does have a plan.

Q. The S&P 500 has returned nearly 16% annually for the last 11 years. What are your expectations for equity returns in the US for the next decade?

Remember that 10 years ago, stocks were cheap after the global financial crisis. Now they’re not. Over the coming decade, we expect US stocks to deliver a nominal return just shy of 2.5 per cent per annum, plus or minus about 3 per cent.

This return expectation is based on our assessment of the “building blocks” of long-term returns. As of July 31, US stocks had a current dividend yield of 1.9 per cent, capital growth expectation of 3.3 per cent (combining 2 per cent from inflation plus 1.3 per cent from real growth, matching the past 100 years average), and an expected valuation change of  2.7 per cent per year, which would still leave us over 30 per cent rich relative to history, resulting in a long-term nominal return expectation of 2.5 per cent.

Changing valuation levels tend to swamp the other two factors for short-term investors, but in our view, yield-plus-growth is utterly dominant for truly long-term investors.

Q. Which are the sectors or pockets of the market that you like in the aftermath of the pandemic? Which businesses have fallen out of favour or face bankruptcy?

Most of the best opportunities aren’t in the US, where markets are propped up by stimulus that’s larger than the rest of the world combined. International stocks are cheap and emerging markets' “state-owned enterprises” are deeply out of favor. Will many go bust in the Covid crisis? Hardly. And they sport a dividend yield of around 5 per cent today.

As for which businesses face the threat of bankruptcy, enterprises tied to travel or high-density gatherings of people, as well as those that rely on global supply chains, are at risk. For instance, if China’s economy reels, problems in the supply chain may ripple across supply chains around the world, potentially leading to rolling bankruptcies all over the world.

But this is already reflected in relative pricing. Over half of the Russell 1000 Value index would have to go bust to justify today’s gaping spread between growth and value. That’s not going to happen.

Q. Central banks worldwide resorted to printing money in the aftermath of the global financial crisis. That worked to an extent in helping the global economy back on its feet. Now, the same measures are being employed amid the Covid-19 pandemic as the world economy catches a flu. Is this a step in the right direction? What are the likely pitfalls of this move, and are there any alternatives that policymakers could have explored?

I wish fiscal and monetary “stimulus” weren’t called “stimulus". It doesn’t stimulate anything; it transfers wealth from future spending to today. And, if the supply of goods and services is sharply eroded, as it is today, all we’re stimulating is asset bubbles and future inflation. Fiscal stimulus certainly helped to keep the economy functioning in the early stages of the Covid crisis, but the consequences of this massive spending binge and money printing is likely to be devastating.

One must also ask how much of the $3 trillion already spent – not to mention similar money-printing – has gone to productive causes. I’ve spoken to US senators who privately estimate that $2 trillion was simply wasted.  

Our economy has two growth engines, established businesses and entrepreneurial capitalism, which consists of both the creation of new enterprises and new initiatives within established businesses. When government policies discourage risk bearing and new initiatives, money stops flowing into product innovation, which impedes future economic growth.

Q. Will all this excess liquidity fuel bubbles in different asset classes?

Excess liquidity from massive fiscal and monetary stimulus fuels asset bubbles or inflation or both. My guess is that it will be both. We favour asset classes that are deeply unloved and trading at attractive levels. Such bargains today include emerging market stocks and bonds, and US energy stocks.

Q. Indian equities have seen a sharp rebound from their March lows. The rally seems to be divorced from ground reality as the economy is likely to contract this year. What are your views on Indian equities, especially when compared to other emerging markets? Are there any stocks or sectors that you are particularly bullish on or worried about?

All of these rallies around the world are divorced from economic reality, unless we consider that stimulus monies must go somewhere; if people don’t want to (or can’t) spend it, it fuels asset bubbles.  As of July 31, our nominal return expectation for Indian equities, as represented by the MSCI India Index, is 5.9 per cent per annum over the coming decade. Indian equities are trading at a CAPE ratio of 20.4x, which is a tad below its historical median level of 21.3x since 1994. The broad EM equity basket, as represented by the MSCI EM Index, is currently trading at a CAPE ratio of 13x which is within its cheapest historical quartile since 1995.

Q. India is trying to clamp down on overseas money coming from China and Hong Kong, either through foreign portfolio investors or foreign direct investment. Do you think this is a step in the right direction given the heightened geopolitical tensions between the two countries?

A. I am sceptical that a policy elite, whether in Washington, DC, or New Delhi, or Tokyo or Brussels, can make these decisions better than millions of citizens, deciding where to live, where to work, where to invest and where to spend. In the 1980s, there was alarm about the Japanese buying marquee properties in the US (Pebble Beach, the Rockefeller Center). I thought the alarm was ridiculous, as the properties were never going to leave the country.

Q. The number of Indian investors investing in US equities as part of their diversification strategy has seen an uptick of late. What is your advice to these investors?

I’ve regularly said that diversification is key to better long-term investor outcomes, and that diversification is useful over the course of an economic cycle. For those investing in US equities as part of their diversification strategy, avoid bubbles and fads. Seek the feared and unloved assets trading at cheap valuation levels. The easiest words in investing are “buy low, sell high” but it’s the hardest thing to actually do.

Q. You have been a value investor for the most part but the gap between growth and value is the widest it has ever been. Could you explain the challenges that value investors face in the current environment?

The biggest challenge is not the markets, it’s the customers. We’re in an industry where no one likes a bargain. The opportunity for value today is extraordinary. The spread between value and growth valuations is the widest it has ever been – even wider than the tech bubble. Fear has driven value companies to some of their most attractive, bargain-basement levels, while growth companies are priced at some of the most expensive, bubble-like valuation levels in history.

In our study "Reports of Value's Death may be Greatly Exaggerated", the prolonged underperformance of value stocks relative to growth stocks is entirely explained by value becoming ever-cheaper relative to growth, leading to today’s abnormally wide valuation dispersion, regardless whether we use P/E ratios or price/book or price/sales. History tells us that when valuations are anywhere near as stretched as today, there’s an extraordinary prospective return premium for value investors. History also suggests that when value rebounds, it comes back with a vengeance: the recovery is sharp and swift.

Q. Trump or Biden? Who are you betting on to win the US Presidential elections? What are the key implications of a Biden or Trump win, especially on the equity and bond markets, and in shaping the global economy and trade?

This election could easily go either way. I’m a libertarian, conservative on fiscal issues and liberal on social issues, which neither party serves particularly well. I’d give Trump a B for his presidency and an F for style. I do not agree with him on immigration or international trade, but his economic policies have been outstanding. I am fearful that I’d give the opposite marks to a Biden/Harris ticket. But, who knows?

That said, the impact on markets is probably far more ambiguous than either side would like to admit. French stocks rose 400 per cent during the socialist Mitterand years. Why? People were reluctant to spend, because they were uncertain about their future, and entrepreneurs were wary of investing in long-horizon risky initiatives, because they feared hyper-regulation or even expropriation.  So, what did people do with any spare money? They put it in the markets. This is the same driver behind the stupendous 6-month rally off the March lows this year.

Q. The Fed has announced a shift in its inflation targeting policy with average inflation -- which means that it will allow inflation to rise over 2%. What do you make of this move and its implications for the bond market? What sort of returns should one expect from the bond market for the next decade?

Peter Bookvar recently published “The Ten Flaws of Inflation Symmetry,” and addresses this question better than I ever could. Two per cent inflation is not price stability. A hundred dollars bought five ounces of gold 100 years ago; today it buys barely a gram, one hundredth its purchasing power in 1920. And, if last year’s inflation was 1%, that’s a terrible rationale to aim for 3 per cent this year.  

Furthermore, central bankers dread deflation, regardless the reason. Deflation from collapsing demand or falling wages is bad. Deflation from soaring productivity, as a consequence of technological innovation, is wonderful. Does anyone really think it’s a bad thing that a 32” HD TV from Toshiba currently costs $99, which is less than an unreliable 15” black and white TV, with terrible image quality, cost 50 years ago?

Over the coming decade, we expect nominal annualised returns of -2.1 per cent for U.S. long Treasuries and 1.3 per cent for U.S. short Treasuries. As for core bonds over the same span, we are forecasting long-term nominal returns of 0.7 per cent for U.S aggregate bonds and 1.1 per cent for global aggregate bonds. These forecasts, all of which are negative in real terms, assume that the Fed achieves its 2 per cent target, and that real yields are forced by supply and demand back into positive territory at some stage in the coming decade.

This is what Keynes called the “euthanasia of the rentier.” Anyone reliant on a fixed income, including the tens of millions of baby boomer retirees, and more tens of millions to come, is facing the euthanasia of their retirement dreams.

Q. US business activity has snapped back to the highest since early 2019, according to reports. US home sales rose for the second straight month amid a steep rise in jobless claims. What is your assessment of the US economy at this juncture, given that Covid-19 cases continue to rise at an alarming rate and the possibility of a second wave?

I’m not worried about a second wave of Covid-19.  It’s already happened and was small relative to the first wave. Deaths ran at half the April levels. Cases soared, but that’s just because mass testing had not yet started in April.

The economic rebound since the dark days of March and April is impressive.  Still, Jim Bianco likes to point out that a “90 per cent economy” – one that’s running only 10 per cent below its capacity – is actually pretty bad.  The Global Financial Crisis was a 95 per cent economy, and we certainly don’t remember that time with any fondness.

Home sales are another manifestation of fears of inflation, fears of the euthanasia of the rentier (negative real yields), and “TINA,” there is no alternative.  If you don’t want bonds yielding less than inflation, and don’t want stocks at 32 times their ten-year average earnings (a level exceeded only during the tech bubble), maybe buy a house to protect against inflation.

Despite these pockets of success, the economic repercussions of the Covid-19 lockdown are far from over.  Bankruptcies have mostly been delayed, not averted, and the same holds true for back rent, back mortgage payments, and delayed debt service. These other shoes have yet to drop.

Q. The dollar as a currency has been wobbly of late. Is its status as the reserve currency of the world in jeopardy in any way?

Given our massive fiscal and monetary “stimulus,” on a scale larger than the rest of the world combined, the erosion of our clout as a reserve currency is inevitable. Nonetheless, the dollar will remain the dominant currency for trade settlement for many years to come.