Friday, August 02, 2013

Ben Inker Q&A: High Profits, High Quality, and China Bubbles

Kinnel: I'm intrigued by a line in your latest commentary hot off the presses in which you said, "There is no asset class that you can hold that would be expected to do well if the real discount rate rises from here." So, what does that mean we should do--just hold cash?

Ben Inker: No, it definitely doesn't mean we should only hold cash, because all asset classes are to one degree or another trading higher than their historic averages. You can make a case that maybe European value and emerging-markets equities aren't, but if you adjust for things it's not even clear that they are cheap relative to historic averages. The reason everything looks that way is we have very low current discount rates, very low cash rates, and very low expectations of future cash rates.

So, you are getting paid for taking a risk of owning something other than cash. The trouble is if those cash rates normalize, then everything whose price was pushed up by the very low cash rates would be expected to get hurt. And if that happens, and it's not guaranteed to happen, you get events like we saw in late May and June, where asset classes all around the world that normally seem unrelated to each other get hit simultaneously.

That is a risk that exists today in the markets because of the very, very low discount rate. That makes everything somewhat riskier, but it doesn't mean you want to sit there and hold cash unless you know rates are going to rise soon because sitting in cash you are earning nothing and in the meantime sitting in other assets you're earning something. So the better an idea you have of when cash rates are going to normalize, the easier it is to figure out what portfolio you should have.

Kinnel: So you're saying it makes sense to be cautious, but don't flee the market?

Inker: So we are running more cautiously than normal, but not hugely so. We're not in a situation we were in say in 2007, 2008 when we were trying to figure out exactly how little the clients would let us get away with having risky assets and going there because in 2007, 2008 you weren't getting paid for taking risks. So, if you're not getting paid for taking risk, you might as well not take it.

Today you're getting paid for taking risk. But, we worry about what happens if cash rates go back to normal. Normally, you don't have to worry about that because normally cash rates are normal.

Kinnel: I think an interesting feature of your forecast is you've had U.S. high quality with a modest but decent return, and then the rest of U.S. equities with a negative seven-year forecast. Would you explain how that might happen?

Inker: Sure. We quite like the quality stocks relative to the rest of the U.S. market for two basic reasons. One of them is for one of the very few times in history you can buy these guys at a discount to the overall market. So they are trading at a lower P/E than the broad market. Normally they trade at somewhere between a 10% and 20% premium. So, that's pretty cool. You get to buy high-quality stocks at a discount.

The other reason we think they are particularly appealing versus the rest of the U.S. market right now is the biggest reason why we dislike the U.S. market: It is not its current P/E, but the fact that the earnings that make up that current P/E are at all-time highs and, from a profit margin perspective, we think are quite stretched. So we think profit margins are likely to be coming down over the next three to five to 10 years in the U.S., and under those circumstances, the quality stocks have this nice feature that their profitability is much less volatile than that of the rest of the market.

So, a narrowing of general profit margins doesn't leave these guys unscathed. In a recession,  Coca-Cola (KO) and  Johnson & Johnson (JNJ) and the rest of them all face more trouble than when times are really good, but the big, stable, high-quality stocks are less at risk if general profit margins fall, at least under our analysis, and that means you're getting two benefits. You're getting less expected fall as profit margins narrow and you're getting less fall as P/Es decrease. Because we think even these guys have slightly too high a P/E and slightly too high a profit margin, which is why we're saying 3.7 real instead of 5.5 to 6 real, which we think is normal for equities.

Kinnel: Can you give us a brief explanation of how you define quality or high-quality?

Inker: For us a high-quality stock is the stock of a company that has high profitability across the economic cycle, stable profitability, and low debt.

Kinnel: In Aprilyou wrote about how corporate profits have been very high for a long time, leading you to wonder why reversion to the mean hasn't hit yet. What's your current thinking on this?

Inker: The behavior of corporate profits in the U.S. for the last 10 or 15 years is weird. It doesn't follow a standard capitalist script. If you've got a situation where there is a very high return on capital, which there has been on average for the last 10 or 15 years, you would expect to get a lot of investments. If the return on investment is high, capitalists go out there and invest. [If] the return on investment is low, they don't.

Well, the return on investment has been high, and yet we have been investing really quite little. There was a burst associated with the Internet bubble, but since then investment has been somewhere between a little bit anemic and, today, downright depressing. That doesn't do anything for expectations of future growth, because productivity growth really does require investment and we're not getting much investment. So, it's hard to see how we're going to get productivity growth, but profits for companies are really less about productivity growth and more about the return on capital. And if you are not getting a lot of investment, then you don't get one of the avenues towards pushing profit margins back down. Normally, higher investment would happen and that would lead to higher competition and the erosion of profit margins. So, if we're looking for reversion in profit margins, which we are, it's sort of the longer-term more subtle issues about what does it mean to have high profits in the corporate sector that is not accompanied by high investment.

When that doesn't happen, the economy can face inadequate demand. So, the corporations--if they truly are just sitting on cash--you have a problem, because nobody is spending that cash. If they do spend that cash by paying out dividends or buying back stock, the problem is that it disproportionately goes to rich people--and rich people, by and large, have a lower propensity to spend income than the rest of households.

So, even if they pay it out, it's just not clear where the demand is going to come from in the economy, and for a while that was buoyed up by spending associated with the housing boom, barring a move back into those unsustainable housing bubble condition. It's not clear how that happens. So, our best guess is that profit margins will be under pressure for the next five or 10 years, just because of the unsustainability of supporting demand without sufficient household income growth. You can see it in the resource sector where lots of people have spent a lot of money, building new iron ore plants and new capacity to get iron ore to market, that creates additional supply. And at the same level of demand, you would expect prices to fall. That's the nice straightforward microeconomic issue. What we think is going to be happening to profits is kind of more of a macroeconomic issue.

Kinnel: Emerging markets are the brightest spot of your forecasts with a 7% real return forecast, which is interesting given that this year a lot of the news has been about a slowdown in China.

Inker: Well, we have not actually been acting as if we believed that 7% forecast. That 7% forecast is assuming everything goes back to normal, and one of the things we've been concerned about and that we have written about is the problem of China. And my colleague Edward Chancellor has been writing about it for a couple of years--that, as we see it, China has a fixed-asset investment bubble and a credit bubble and a real estate bubble. [That's] not the same thing as having a stock market bubble, but it has significant implications for not just the Chinese stock market, but for all of emerging markets. As a result, we have been more cautious on emerging markets than our forecast would suggest, and we still are.

Emerging markets have some real problems, and we are trying to figure out exactly how they will play out. We still think you've got to own some, because they are pretty cheap even if they do have some problems. And certainly having underperformed the U.S. by 27%, 28% so far this year, they are getting more attractive. I'm not sure they are quite as attractive as the forecast, which is assuming we get to go back to normal, when it isn't entirely clear what normal is for these economies.

Kinnel: And, of course, these are return forecasts, not risk return forecasts.

Inker: Yes, but we are not just saying that. We could say it's going to be 7%, but it's going to be a bumpy ride, so hold on. We're perfectly happy to hold assets where we think the ride is going to be bumpy. The biggest concern we have is effectively that 7% return is assuming that more or less all of the very strong growth emerging markets have had for the last decade was secular growth. If some portion of it was instead this cyclic goal issue of selling into a bubble in China and when that bubble bursts, the sustainable level of sales and earnings and assets will all be lower, then it's not just that you get a bumpy ride, but you're not going to get the 7%. And that's what worries us more.

We're perfectly happy to take a volatile 7%, and again we do own emerging markets and may well start buying some more over the next couple of months, but the big concern is we don't quite believe it's as cheap as our standard analysis makes it look.

Kinnel: You're still forecasting negative real return for bonds even though rates have backed up a little. I gather bonds are still not attractive to you.

Inker: Not particularly attractive. We have started to buy some TIPS, and it's not because we think TIPS have a much higher expected return than traditional bonds, but because of the inflation protection. We think they are less risky, and since we have a bunch of money sitting in cash today, diversifying some of that into TIPS make sense, even though we really don't love them at these yields.

But we have started to buy some. They're the first bonds outside of emerging debt that we have bought in quite a while, and it's a 10% position, so it's not huge, but it's the first increase in duration we've had in a while. And it's on the back of the backup in yields, which has brought the TIPS yields to be positive, if not as high as we'd like them to be.

Kathryn Spica: Touching on emerging-markets debt, it seems like according to your forecasts, it's the best of the worst among bonds. How are you looking at that segment, and what's been attractive about it?

Inker: Well, what is attractive about emerging debt is pretty simply the yield relative to the other things you can buy. The yield spread is a little bit narrow to our best guess at equilibrium levels, but one of the things about emerging debt is, unlike say high-yield, which is defined in terms of its credit quality, emerging debt's credit quality can change over time. And it has been getting better.

So, our view is its fair spread over Treasuries would be 3.5% maybe, and it's trading at 3.2%. So, that's pretty close to normal. The problem is it is normal on top of a Treasury bond, which looks worse than normal, but we feel like you've got to own some here. We don't think you want to be near the maximum position by any means, but it's a somewhat different risk than other risks you're taking in the portfolio, and you're getting compensated for taking it.

So, we think it makes sense to own emerging debt. The emerging debt we like most today is hard currency sovereign. The corporates don't make a lot of sense to us at today's spreads and the local debt is hurt somewhat by the fact that we don't think these currencies are all that cheap.

Kinnel: Timber has long been an area for which you had fairly high forecast returns. What's your outlook, and how can a planner put clients in timber if they want to?

Inker:  Today's expected return to timber is OK, but not better than that. One of the things you have to recognize when you are investing in timber is you're locking up your money for 10 to 15 years. And that takes away a lot of flexibility, and you should get paid for giving up that flexibility. So, the 5.9% return that we're saying today, is OK, but it's not better than OK. And even to get to the 5.9%, that's really driven by lower returns maybe about a 5% return on U.S. forestry assets and something like 6.5% from non-U.S. forestry assets.

So, if you want to get good returns, you got to go outside the U.S., and it is hard for most investors to invest in timber in the U.S. It's even harder outside. The problem of trying to invest in timber is that neither the forest and paper products companies nor the timber REITs is a really good steward of their forests, because they both have incentive to cut at the wrong times. If it's a forest and paper products company, they've got mills. They have to keep running because they're very expensive to shut down. So, even if the price of the logs is lousy, they'll keep cutting.

For the timber REITs, they have a somewhat related problem in that they're priced off of their dividend, and so they will keep cutting even if the price of logs is lousy. And one of the things we've always loved about timber relative to other agricultural commodities is if you're growing a corn crop, and the price of corn is not to your liking, you have no choice but to harvest your corn. So you will get a lousy return on it, because the price is much lower than you are counting on.

If the same thing happens with your forest, you don't have to cut down the trees. They'll keep growing. They'll get more valuable. So, if you owned forest land during the housing bust in the U.S., one of the things you can do is cut fewer trees with the expectation that as housing activity comes back up, the price of lumber will come back up and your returns will come up. So that really requires either owning the trees directly or investing in timber limited partnerships, both of which are difficult and time-consuming.

So, it's unfortunately a very difficult asset class to get at, much more comparable to private equity, than the other things on our forecast page.

Kinnel: You at least have positive return projections for Europe. Why?

Inker: Our outlook is better than the U.S. because the valuations are lower and expectations are worse. They have been going up, not quite as fast as the U.S., but still reasonably quickly this year, which has left their valuations looking less interesting. What we do see that looks pretty interesting outside of the U.S. is there is a pretty big gap between the growth companies and the safe companies relative to more cyclical deep value type names, which are looking interestingly cheap. They are risky.

If you look at the European markets, more cyclical companies are cheaper, more leveraged companies are cheaper and more European companies are cheaper. If a company does all of its business in Continental Europe and is cyclical, it's going to get hurt a lot worse, or it has gotten hurt a lot worse, than something that was more globally diversified and more stable.

So, the market isn't being capricious here, but the market is saying effectively it doesn't believe Europe is going to recover. You're getting paid for taking the risks, for willing to take a bet that Europe will recover. We are prepared to take that risk, but since it is hard for us to see exactly how Europe is going to recover quickly from here, we own an amount of European value such that we could own a good deal more if the price were to fall from here. So we're not all that close to our maximum allocation, but we own a pretty decent chunk because it's one of the cheaper things out there.

It is this strange inversion of what we see in the U.S. though. In the U.S., high-quality companies are trading at a discount and it's because they seem less special in a world where everybody's making lots of money. In Europe, the high-quality companies are trading at a pretty big premium because the ability to make money and the assumption that you will continue to make money seems to make them special. So, we are seeing a big discrepancy between the pricing in the U.S. and outside of the U.S., which means the kinds of companies in Europe we are interested in tend to look pretty different than the kinds of companies we're interested in within the U.S.

Kinnel: Do you differentiate within Europe from among the euro-denominated countries and the United Kingdom and others outside the euro?

Inker: Yes, although it's somewhat interesting. The U.K. actually looks decently cheap, as does the eurozone. Continental Europe ex-the eurozone, which I admit is this slightly strange combination of Switzerland, Sweden, Norway, and Denmark, doesn't look anywhere near as attractive as the eurozone, but the U.K. does look pretty close to as attractive as the eurozone. So we like the U.K., we like the eurozone; we don't much like the rest of the Europe.

Kinnel: What about Japan? There's certainly been a lot of interest in Japan, given its recent changes.

Inker: Yeah, we were big fans of Japan nine months ago and we thought it was the cheapest thing out there and we had a pretty significant overweight or pretty significant allocation. We've been selling in recent months and we no longer think it's particularly intriguingly priced. Nine months ago Japan was priced as if it was never going to get any better, and so you could buy it and say, well, if it never gets any better, it's priced to do okay, and if it actually gets its act together, it's priced to give you a really good return. Since then, since the pricing has changed, you are paying for the expectation that it will get its act together. While Abe and the new government have made some of the necessary moves to get there, it is by no means assured that they will get their act together. So I much prefer a free option to one that I'm paying for, and on our analysis you're paying for that option now, which makes it, not horrible, we still own some Japan, but it is certainly no longer one of our favorite markets.

Spica:  What are the challenges for implementing any of these forecasts or any of your views?

Inker: There is a little bit of difficulty. One of the reasons--I talked a bit about the fact that we don't act as if we believe the 7% for emerging equities. One of the reasons for that is the 7% is based on the valuation of the emerging companies. If you buy the companies, to some degree you get the currency along for the ride and the problem today is the currencies look a little bit expensive. So if you try to buy the emerging stock, you've got two choices. You can keep the currency and have some expected erosion of your gains from the fact that the currencies will weaken, or you could try to hedge the currency. But that's going to cost you. So emerging is in this slightly weird case where you can either keep the currency or get rid of the currency, in either case you're not thrilled with it. Otherwise, most of the other forecasts you can – we are expecting over the next seven years you will get these returns, with plenty of volatility around it, but they are our best estimate of the returns. The bad news is there's just not that much to be excited about.

Kinnel: You pointed out some of the issues with the risk parity strategy have kind of come home to roost lately. What's your take on what the recent markets have shown about risk parity strategy?

Inker: Well, there are a couple of things. The different risk parity implementations have different underlying assumptions behind them, but what a lot of them tend to assume is that the correlations between assets are going to be low. What the events of this spring showed is that's not always true, and what we think it's important for people to realize is what happened in May and June wasn't this weird, random event, meteorites striking the Earth in a way that's not happen again and could never be predicted. This is what you should expect to happen if cash rates normalize. It's not a guarantee that they will normalize, but it's a risk that's sitting there if you put together a portfolio and said, it's okay to lever this thing because the low correlations mean I'm going to be taking losses on one thing while I've got gains on another. That is absolutely not guaranteed to happen. You can rely on it less today given how low rates are than you could under normal circumstances.

The other problem we see with risk parity is that it's assuming that risk premia exist rather than checking to see if they exist before investing. So the assumption was that even at a yield of 1.6% on the 10-year, that 10-year bonds offered a risk premium over cash, it was far from clear to us that at those levels they did. Now, maybe at a 2.5% yield they do or certainly at a 5% yield they would, but the two things we think you really got to lookout for, and that we think in various ways a lot of the managers of risk parity ignored were, first and foremost, the correlations that they're assuming are going to be low are not always low, and we're in one of those situations where they could easily be higher in important and dangerous ways for an extended period of time.

The second one is just that just because an asset class has provided a return above cash historically does not mean it's priced to do that today. Levering up an overvalued asset class doesn't make it cheap. It is just a recipe for losing money.
Kinnel: Thanks Ben.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.