[private] 20th April 2013
Q and A: Sandy Nairn, CEO, Edinburgh Partners
Sandy Nairn, the CEO of Edinburgh Partners, has been a regular contributor to Independent Investor over the years, making several highly prescient calls along the way. He was extremely cautious in November 2007, just as the markets were starting to anticipate the full extent of the banking crisis, and bullish once more in March 2009, when the equity markets finally bottomed out after the severe 2007-09 bear market. Two years ago he made the case for investing in Japan. In the first part of our latest interview he argues that investors are overpaying for perceived safety: government bonds and companies with stable earnings are much more vulnerable to disappointment and capital loss than investors appear to appreciate.
Are current market valuations credible?
Market valuations look unusual. It is fair to say that markets often tend to be somewhat unitary in their outlook. When things are going well, they focus only on potential returns and when things are going badly, only on potential risks. Against the backdrop of the financial crisis the focus for the last four years has been almost exclusively on risk. This has now produced some significant pricing anomalies.
Let’s start with the US bond market. With US bonds on a negative real yield, either investors are predicting a slide into deflation or they are exceptionally fearful about short-term capital preservation. Falling inflation seems to be a difficult view to sustain given that inflation is showing few signs of turning negative and the Federal Reserve has explicitly indicated that interest rates will be kept low for as long as necessary. Indeed markets are now expecting not just QE3 or QE4, but QE Infinity.
Given that there’s no sign of negative inflation anywhere in the world outside Japan, then it seems that investors must be fearing another crisis or financial collapse. It is an understandable human impulse. But it is also surprising because, when you look at the historical charts, whenever you’ve bought a bond with a negative real yield, you’ve been pretty much guaranteed to lose money on it. The only question has been: how much money?
Investors may have good reasons to be fearful, might they not?
Confidence certainly remains fragile. Investors remain highly uncertain about the immediate economic outlook. Concerns over Chinese growth, the future of the Euro and the US “fiscal cliff” make forecasting with any confidence difficult. Investors’ main reaction has been to pay up for anything that seems to offer some degree of capital protection. The strongest credential of US treasuries is that they are backed by the US Government. The probability of the nominal face value not being returned is negligible.
The fact that US bonds have been on the longest bond market bull run in history may however be blinding investors to the potential perils of buying a bond on negative real yields. This goes to the heart of what to be fearful about. Since financial markets discount the impact of future events, the investor’s greatest fear should be reserved not for events themselves but for overpaying for an asset which is the expected beneficiary of those events.
In my view, the idea that neither growth nor inflation will return in the foreseeable future is dangerous. Few investors are explicitly positing this as a likely outcome, yet it is what is embedded in government bond prices. Even if it is logical to retain concerns about the global economy, it does not follow that the answer is government bonds. Fear needs to take in the level of valuations as well.
And that fearful mindset has spilled over into other types of assets too…
It is normal in asset markets that investor perceptions change in a fairly uniform manner across different asset classes. If the safe haven argument for bond prices is correct, then in equity markets one would expect to see a similar premium for predictability in equity markets. And that is exactly what we have been seeing – just look at the pattern of equity valuations over the past three years or so.
One way we look at this is to take the global universe of stocks and rank them according to the volatility of their earnings growth rates. The ranked stocks can then be split into quintiles. What you find is (Figure 2) that the stocks in the lowest volatility quintile are now at their highest valuation premium they have ever been relative to the rest of the universe. These extremes tend to be reached during periods of economic stress, but are then typically followed by sharp reversals.
Another approach is to look at a specific sector which typically has a relatively stable earnings profile and compare its valuation to that of the global index. Consumer staples, companies which sell things like household goods that consumers have to keep on buying whatever the economic climate, are the obvious example. The picture here is the same. The extreme valuation stands out whether one looks at relative p/es (Figure 3) or at dividend yields (Figure 4).
Might not this simply reflect better earnings performance?
Unfortunately there is no evidence that this is the case. In the long-run the ‘steady’ growers have not displayed any faster earnings growth than those companies with a more volatile earnings path. These relative valuations are consistent with what is going on in the bond markets. There has been a flight to any kind of investment where there appear to be the fewest ‘unknowns’. In other words, investors are equating lack of volatility with safety and a lower risk of loss. This has the effect of skewing prices away from normal valuation levels.
To a degree, that is fine, but what is worrying is the associated view that these things are somehow “safe”. They aren’t, any more than government bonds are safe of current levels. There’s really only one set of circumstances that would make holding these types of stocks the right thing to do. That is to protect yourself against ‘tail event’ risk. It’s very hard to find any other reason to believe that this approach will be a productive one in terms of returns, given where valuations are now.
You are saying that safe assets generally are overpriced now?
Yes. My view is that so-called safe assets have simply gone up too far. I think what markets have been doing, progressively over the past couple of years, is confusing what risk actually is. Predictability doesn’t mean an absence of risk. After all, it’s not that people don’t know that bonds are expensive. Everybody knows that they’re expensive! Yet they still own them. We have seen that before at market turning points. It wasn’t that anybody didn’t know that the Japanese equity market was expensive back in the late 1980s, for example. Everybody did. Yet they still owned Japanese stocks.
It’s the fear of taking a different view from everyone else that investors find so difficult to do. It is hard work arguing against somebody who says they own high-quality companies with predictable earning streams. If you say “Well, they look a bit expensive to me”, people look at you as if you’re mad. Why wouldn’t you own a high quality stock? It’s a powerful argument to overcome, particularly when nobody is suggesting that the global economy is suddenly going to go back to 3%-4% growth.
What does that imply for future returns?
If you look at the long run history of real returns for both equities and bonds (Figure 5), the magnitude and duration of the recent bond bull market is obvious. But remember what happened to returns the last time inflation was at today’s levels, which was in the 1950s and 1960s. That was a period in which the post-war US debt/GDP ratio declined sharply, largely through the mechanism of prolonged but moderate inflation. The reaction of the bond market, quite logically, was to demand higher yields in anticipation of the inflationary threat. That in turn triggered the start of the bond bear market which ran all the way from the late 1960s through to the late 1970s. It is not unreasonable to argue that conditions today are not hugely dissimilar to those that prevailed in that post-war period, in which case you would expect bond yields to be rising rather than falling.
How quickly might these valuations revert to more normal levels?
It would be logical to expect that any signs of renewed stability in the global economy will be met with a change in investor perceptions. We are starting to see those signs in the United States. Although inflation briefly went negative during the financial crisis in 2008, it has since returned to a more normal 2%-4% band. In addition, even though the pace of US economic recovery has disappointed, both the US and global GDP growth rates we are now seeing are consistent with prior historical experience.
In other words, although some parts of the world are still struggling to repair their balance sheets after the crisis, it is hard to argue that the global economy as a whole is not displaying a fair degree of resilience. Even with all the issues that face the world a real global GDP growth rate of 2-3% is not unrealistic. Combined with inflation of 2-4% this would give nominal global GDP growth of 4-7%. Against this backdrop one would expect similar levels of profits growth for the corporate sector.
Will there be a bond market crash?
The enemy of the bond market these days is not a new economic boom. It is simply an economy that’s doing okay. If you have a global economy with nominal global GDP growth of 4-7% it is inevitable that investors will gradually start to think “I don’t want bonds at these prices”. If you look at the experience of the 1950s, what happened was that bond prices didn’t crash, they just ticked down. Every time there was a new issue, the yield had to go up a bit because inflation didn’t come down. So, the enemy of the bond market is people starting to relax. They think “I just don’t want to hold these bonds anymore”.
QE is playing a part in this too. One reason why bonds have held up so well so far is because one arm of government has been selling to another arm. Eventually that has to stop, or at least slow down. However, the central banks have been completely politicised. I find it very hard to see a circumstance where the market has reached stability, the bond market as a consequence is falling, and the Federal Reserve simply sells its holdings into that market.
I just can’t conceive of a set of political circumstances that would allow that, even though the Fed is nominally independent. In practice they’d be accused of creating a bond market rout. So I think the bond market will simply slide its way down into a prolonged bear market, rather than crash. It is going to be a gradual process.
The problem is that QE is highly addictive for financial markets. Some commentators argue that QE cannot be removed in the foreseeable future precisely because of the negative impact on government bonds. But is it really the role of a central bank to artificially fix the price of government bonds or become the holder of last resort? As the point where an end to QE approaches, those assets whose prices have been inflated either directly or indirectly by the policy will surely come under pressure.
The first to suffer will be government bonds and ‘safe’ equities. But it is also reasonable to assume that with the cost of money having been chased ever lower, this has contributed to speculative demand in a range of other assets. Commodities have benefitted both as a perceived hedge against future inflation and as a speculative vehicle in their own right. They too could become vulnerable as and when the monitory tops are turned off.
What impact would a return to normal valuations have on the bond market?
Let’s suppose, for example, that 10 year US Government bonds were priced to give a real yield of 2%, rather than their existing negative real yield. That seems reasonable. A 2% real yield is consistent with the long-term average for US bonds. Since the 1870s the real yield has been 2% or greater more than two thirds of the time. Negative real yields occur less than 15% of the time. If we go back to a 2% real yield, the price of the ten year bond would need to fall by 15%-20%. Not much capital protection there!
Meanwhile the central banks of the world have made it perfectly clear that they will not countenance the risk of deflation, and despite all the worries about economic growth, the inflation rate is still above 2% in the US. All it will take is for investors to decide that the constant erosion of their purchasing power is unacceptable and the bond market will be in trouble. Extending the same logic, if inflation were to drift up to, say 3% per annum, then we would be looking at a bond market decline of around 25%. That should be worrying investors more than it is.