"In India, valuations appear stretched and growth projections unrealistic"

What’s your current market assessment? How have you positioned your portfolio?

We see that most asset classes around the world are expensive relative to their own history. They make more sense relative to each other. Take the obvious example of US cash and bond rates, which are very low versus their long-term history. But bond rates kind of make sense when compared with cash rates. To us, the most striking overvaluation is that of the US stock market. Other equity markets, emerging markets (EMs) in particular, look better. So, we really don’t own any material amount of US stocks anymore. EM equities constitute a quarter of the overall portfolio, and non-US developed markets make 15% of our portfolio. The other striking factor is we own a lot of liquid alternative strategies. We are living through a period where most long-duration assets have been big beneficiaries of falling discount rates. But the biggest risk to portfolios over the next decade would be if those rates start going back up. So, if you can find some short-duration assets that are offering decent returns, it’s a nice way to make money while having less medium-to-long-term risk.

What could make those discount rates go up?

The most obvious trigger would be if inflation started rising again. The biggest economic mystery over the past, say 17 years, is why the developed world has been so resistant to inflation. The market is saying, well, there has been this permanent change. It could be true. It could also be true that this trend is driven by temporary factors. One is — the rise of China as a manufacturing center. Once they joined the WTO, their share of global exports exploded. But their ability to absorb evermore share of manufactured goods may be ending. There really aren’t underemployed people in their rural economy anymore, so they’ve run out of extra people. Another obvious factor is in terms of the ‘Phillips Curve’. The relationship between unemployment and wage growth has been much weaker than it used to be. It could be because of globalisation of labour markets. Again, there are quite a number of jobs that aren’t as portable. I look at market valuations today, and the market seems to be utterly convinced that we’re nowhere near the end; because the markets are priced as if the potential of inflation is non-existent. And that’s dangerous. We could get material wage growth. And if we did, the Federal Reserve would quickly realise we’re not at neutral interest rates, and we’re going to have to go above neutral to control this. 

Could rising wages in the US market act as an inflationary factor, since US unemployment is the lowest since 1969 right now?

US unemployment is very low. Whenever we have hit this low, there’s been material acceleration in wages. This time around, if there’s any acceleration in wage growth, it’s been very minor. That’s something of a mystery. Perhaps we are not properly measuring the aggregate available workforce because we’re assuming these jobs have to be filled locally. It could also be because the participation rate in the US has fallen. So, there are plenty of people who aren’t counted as part of the workforce, who can be pulled into the workforce if they thought they could get a job. If that’s true, the economy can put an additional one or two million people to work over a couple of years. At that point, you would expect wages to start accelerating. But, if we are truly looking at a global workforce, then we may be talking about 100 million people. We’re also talking about a global economy. That takes a lot longer to chew through.

Won’t trade wars hinder the mobility of goods and labour?

They certainly could. The US has largely been targeting manufactured goods. That is unquestionably inflationary. It impacts the manufacturing sector and not necessarily the labour markets. Trade wars are very bad. They reduce economic activity and push inflation higher, a very ugly combination. So, I desperately hope we don’t have a big trade war, but I’m not utterly certain we won’t.

The US is going into election year soon. Will posturing take precedence over practical policy?

There will certainly be some kind of posturing in the run-up to the election. One of the things that markets have taken from the various tweets and other statements from Trump is that you don’t necessarily want to pay too much attention to what he says, until he actually does something. At this point, a large body of the posturing that has come up hasn’t really been followed up with policy.

You brought up bond rates earlier. The US 10-year peaked in November, at around 3.26%. Then the market went into a tailspin and the yield fell to 2.34%. Now, it’s around 2.4, but the indices are trading near their highs. What do you make of that?

I think the market was very concerned that the Federal Reserve was going to keep on raising rates. And I’m not sure if the concern was that they would hence drive the US economy into recession, or simply that, those rising rates provide more competition for equities. You know, an acronym that has been used for the US stock market over the past several years is ‘TINA’ or ‘There Is No Alternative’. When bond rates and cash rates are really low, we feel compelled to own stocks, because how else can we possibly make money in the portfolio? So, with the Federal Reserve changing its tune, and making it pretty clear that rates are on hold, there is less competition from bonds and cash. We’ll see what happens to corporate profits going forward, where we are somewhat nervous because we see that profits are extraordinarily high in the US economy. Historically, from levels such as these, they’ve always come down. As we see it, you’ve got two possibilities. One, profits stay at these high levels and the market is merely expensive or two, profit margins come down and the market remains disastrously expensive. So, we are certainly much more comfortable investing outside of the US, where profit margins don’t look all that high relative to history.

But what does the bond market signify, because the yield has not moved back higher?

What the market is saying is that the next move by the Federal Reserve will be to lower rates; that the equilibrium cash rate is lower than the current cash rate. So what the market is saying is bonds don’t need to deliver much on top of inflation for you to own them. And that’s a significant change from the longer-term history, where everybody used to think you need bond yields, of say, 2% to 3% above inflation to make the world work. They’re certainly not saying that now.

In your seven-year-return forecast, emerging markets are a clear outperformer. What drives that expectation and what are the spoilers to the forecast?

We like emerging markets more than developed markets for a simple reason — valuations. If you look at the cyclically adjusted PE, EMs are much cheaper at 14x earnings against 27x for the US and around 21x for EAFE (MSCI Europe, Australasia, Far East Index). We believe cheaper markets outperform. In terms of what could go wrong, historically, there have been a couple of drivers of real problems in emerging markets, outside of overvaluation. One of them is currency crisis. Currencies across the emerging world can get pretty overvalued, particularly when there’s large trade and portfolio flows into these economies. Such currencies have a tendency to fall and, when they do, it’s a problem because of the debt/revenue mismatch. Lots of companies in the emerging world borrow in dollars. Most EM currencies, particularly after the decline in 2018, look cheap. Not stunningly, ‘Oh my God, this is the best opportunity you have seen in a generation’ cheap, but they look cheap. The other obvious thing that periodically bites these economies is credit or bank crisis. The place where that is a potential problem is China. There, banks don’t seem to be really smart about credit rationing. They largely seem to lend to wherever the government tells them to. When we look at the rest of the emerging world, we don’t see a lot of vulnerability. But, China is by far the most important economy in the emerging world. It may be materially smaller than the US economy, but it has grown so much faster that global growth has been very dependent on it. So, a problem in China would be a problem for the world, and in particular, a problem for EMs. The mitigants are, one, the Chinese government has not accumulated much debt and has the potential to bail out the system if it gets into trouble. And the other is that nominal GDP growth has been fast enough in China. 

The euro/dollar, over the past five months, has been moving in a pretty tight range of 1.12 to 1.14. It’s recently broken on the downside to 1.11. Dollar strength is rarely a good sign for emerging markets.

That’s true. I’m not sure whether the Euro is much of a proxy for the overall world. But yes, I mean dollar strength is tough for the emerging world. One particular reason is higher debt service cost, given the currency mismatch. Though there are some negatives to a falling currency, particularly in the emerging world, there are positives as well. When the currency falls, the competitiveness of that economy improves. And the ability of local companies to export and to compete against imports goes up. So, if the dollar were to strengthen in not a really sharp, violent way, and if it were to gradually strengthen, I think that’s pretty good for earnings and emerging markets. If it isn’t something that causes a debt-servicing crisis, it is probably net-net good for the emerging world.

Given your affinity for emerging markets, what is your view on India?

The Indian stock market has spent most of its time relatively expensive. If you compare India to China, capital has been available in China for a long time, but the return on capital is not that high. In India, capital has been scarce. Therefore, companies have been careful about the investments that they make and have had a pretty high return on investment as a result. Even though the Indian stock market has tended to trade expensive in comparison to the rest of EM on average, it deserved some of that premium. But we are underweight on the Indian market right now, largely on valuation grounds. There are just plenty of places where you can get companies a lot cheaper.

Theory says that if earnings don’t catch up with expectations, then the valuation has to correct. In India, we have had anaemic earnings growth for the past three years, but the indices kept heading north.

It’s always a funny thing when you look at earnings and expectations. In the US, there is this long and honourable history of everybody expecting strong earnings growth in the beginning of the year. The actual earnings growth is generally less than what was predicted. During the course of the year, expectations are dragged down. And so, numbers that initially seem to be  disappointing are not treated that way by the stock market. Again, I’m not an expert on the Indian market. But Indian companies have, to a significant degree, been getting some benefit of the doubt about how the future is going to be better than the past. There have been other places around the emerging world where investors have been a little bit more manic-depressive. For example, Brazil was priced for disaster a couple of years ago. Today, it’s priced as if the market is going to grow very nicely. And it’s not clear exactly why; they haven’t really fixed many of their structural problems. 

Given that you are underweight on US equities, have 25% portfolio in EMs and have liquid alternatives, would it be safe to assume that you also have a high portion of cash now?

We’ve got 41% in equities, 30% in liquid alternatives, 23% in fixed income and 5% in cash, so we don’t have a lot of cash. But, we’ve got a relatively low equity weight.

What kind of correction would entice you to increase your equity weight right now?

The US stock market would have to fall quite a good deal for us to get excited about that. You know, 10% to 15% lower from here and we buy.

Would the same apply to the Indian market as well?

India is the most expensive market in our universe by a wide margin. Even adjusting for the higher level of quality we see at the company level, the valuations appear stretched and the growth projections unrealistic. For the past few years, valuations have gotten more expensive, while profitability and margins have languished. The market has aggressively priced in the future benefits of the Modi reform agenda. While we believe most of the past reforms will be net positive in the long run, the market has overshot. We are also concerned about Modi’s ability to conduct and complete future reforms given departures from his staff and his possible loss of majority in the government.

I’ll end with one of the headlines of your last quarterly reports. What keeps you up at night?

What can cause absolute pain to the portfolios and what makes us look bad versus the traditional portfolio? I think the worst thing that could happen to investment portfolios from here on would be an inflation problem. And I don’t know how to really insulate a portfolio against inflation. That’s a worry. Again, it’s not a statement that I am confident that inflation is coming, but I think it is a meaningful risk. What keeps me up at night is worrying if my clients would be unhappier with me, relative to owning a more traditional portfolio. The longer the US stock market continues outperforming, the tougher that is. If the Federal Reserve can be convinced to lower interest rates, while the US economy is still growing nicely, that would be bullish for the US stock market. That would probably hurt us more than a traditional portfolio, since we just don’t own much in the US market. Our portfolios would make money, but not as much money as some others.