Beware the shocks to the system

Alan Brown, senior advisor for Schroder Investment Management in London, shares his bird’s-eye view of investing with Jame DiBiasio.
Alan Brown
Alan Brown

Alan Brown is senior advisor for Schroder Investment Management in London, where he served as CIO from 2005 to 2012. He works closely with the the £263 billion ($435 billion) firm’s biggest institutional clients. He shares his bird’s-eye view of investing with Jame DiBiasio

What’s the No.1 challenge for investors right now?
The issue in developed markets over the past year or so has been the tension between rising discount rates – ie yields – and rising earnings. The question is whether earnings will rise enough to compensate for a rise in bond yields. If interest rates are increased too quickly, we could get into a difficult position.

Some argue that stock valuations have risen too fast, which suggests earnings might not compensate for a hike in interest rates.
I’m optimistic that equity market earnings growth will be enough to overcome a slow rise in interest rates.

Is that because you think earnings will remain robust or because you’re hoping rate hikes will be modest?
The latter. In a business-as-usual world, we would follow the Taylor rule that says interest rates should, over time, reflect average nominal GDP. So that would suggest US short-term rates should be around 4.5%, when in fact they’re close to zero. It will, however, take five to 10 years for the US to get there. In the UK, for example, if the Bank of England increased rates too quickly, it would set off a damaging downward spiral in the household market. [The US Federal Reserve’s] Janet Yellen has recently felt the need to affirm that any interest-rate rises will occur at a slow pace.

How much control over that process does the Fed have if the market stops believing it?
That’s a difficult question. The old bond market vigilantes haven’t been visible. The bond market is now dominated by large-scale, price-insensitive buyers: the central banks. But the Fed’s asset purchases have already been trimmed to $55 billion a month, and that buying programme may end by the end of the year. We might see the vigilantes come back when we get toward the end of that. Treasury issuance will continue but it will be taken up by traditional buyers who are price-sensitive, such as pension funds, insurance companies and banks. The hope is that the yield curve will steepen enough to encourage carry and roll-down trades. Whether this happens is the key judgment investors must make over the next 12 to 18 months.

You say you’re hopeful it will be all right. But what are the factors investors need to watch, particularly if they have liabilities to meet?
There are potential shocks to the system. Europe is close to slipping into deflation and it seems the peripheral countries are already there. A shock could reduce economic activity to a dangerous degree and that could come from a crisis in Ukraine or disruption to energy supplies.

Some argue, in light of last year’s strong performance by the S&P 500, that sustainable equity returns may be a mirage.
I disagree. At current price levels, there is still intrinsic value. In the US, price-to-earnings multiples are in the mid-teens, which I’d say is fair value. It’s not out of line with historical measures. If we have another year like 2013, yes, that could take US equities into bubble territory. But I am hoping the S&P 500 return this year is more in line with earnings, say around 8%, and perhaps 15% or more for small caps. You can put together a basket of large-cap stocks that yield around 3.5%, with expected dividends of 6%. The US Treasury 10-year [bond] is yielding 2.6%. So, on a relative value basis, that still favours equities because bond yields are extremely expensive.

And globally?
The shorthand version says US equities is a quality story, Europe is a value play, and emerging markets are for growth. The question is whether those tag lines are still true. As I said, I think the US market is fairly valued; Europe offers more value but growth is weaker. Currently the most angst concerns emerging markets, which have significantly underperformed the S&P 500. So are emerging markets creating a fantastic value opportunity…or are these prices telling us something fundamental about the state of emerging markets?

What’s your bet: bargains or cheap for a reason?
Many countries have their specific issues: China, Turkey, Brazil. But emerging markets as a whole are still growing at double the pace of developed markets. They often have more favourable demographics (China being a notable exception), lower debt relative to GDP, healthier banking systems and, now, cheap valuations. I think they make for a better value proposition this year.
 

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