I was thrilled to be able to crash a presentation on Thursday from
Martin Barnes, Chief Economist at BCA, who swung into town to present his outlook on the global economy and financial markets to the CFA Society of Sacramento.
BCA produces highly regarded research that is priced at a premium, so this was a great look-in.
Ironically Barnes delivered his level setting of investment return expectations from a CalPERS conference room!
Investing in a Low Return World: Not Fun
Barnes travels the globe meeting with various folks in the finance industry, observing that: “Nobody is having any fun right now.”
He continued that while he’d love to be able to tell us a credible, bullish story to stand out in the current sea of gloom (his eloquent words by the way), he believes it’s a low return environment for the foreseeable future.
Anatomy of a Bull Market’s Beginning
He started out by referencing the three major bull markets in US history, paying homage to their awesome returns:
- 1920 – 1929: 27.0%
- 1948 – 1968: 12.9%
- 1982 – 2000: 15.6%
(Annualized real returns of the S&P 500)
When markets are compounding at these gaudy rates every year, your strategy could have consisted of anything and you’d do well (like buying stocks that begin with “J”, he joked).
In 1982, the situation was ripe for the start of a bull market. The market’s P/E was a mere 7.7 at the time – a far cry from today’s celebrated “cheap” P/E of 14.
Also in favor of stocks in 1982 – a point I had not heard before, by the way – was that the corporate sector of the era was not as lean and mean as it is today, because companies were hiding behind the veil of inflation. Corporate America didn’t need to be efficient – they could just raise prices at will.
When Paul Volcker killed inflation, companies had no choice but to increase margins. And they had a lot of opportunity for margin improvement.
Equities were also, now famously, detested in 1982. They composed less than 20% of household financial assets at the time. Today, equities make up close to 40% (though that’s down from 50% in the late 90’s).
2012 is not 1982
Today, inflation can’t go lower, or we are flirting with deflation. And interest rates are unlikely to go much lower – they are already as low as anyone thought possible.
Profit margins, which were depressed in 1982, are currently at a secular high. He believes margins are likely to come down modestly from here.
Finally while the stock market is not expensive at a P/E of 14, it’s not super cheap either.
3% Real Return: Get Used To It
Barnes called the bond market “a crazy, distorted market.” He believes we have to assume that we are eventually going to get back to a “more normal” world – which would involve higher interest rates.
(If we do not make this assumption, Barnes fears for our personal sanity, pointing out the easy doomsday investment portfolio selections of cash and gold).
If rates do rise, this means in total return terms, government bonds are not going to do us any favors at all – he believes you can pencil in a zero for total returns.
Barnes is more positive about corporate bonds, where he projects 6% returns per year over the next 5 years in, even allowing for some defaults.
His “middle of the road” scenario for developed stock markets is 6.5% nominal returns. It assumes the same market valuation as we have today, with 4% nominal GDP growth (with 2% real GDP growth and 2% inflation).
So we have 5-6% returns with 2% inflation – or 3-4% real returns – which he points out is not bad, or depressing. The outsized returns in years’ past are the real outlier.
Relative Value of Developed Sovereign Bonds and Equity Markets
Barnes quantified the valuations of developed world sovereign debt and believes that on a relative basis the PIIGS debt is the cheapest – namely Greece, Italy, and Spain. 7% yields are not sustainable in the long term, as they’d become insolvent. So if you believe the euro is staying together, these bonds are absolute buys today. (A big IF, he admits).
In applying the same analysis to developed stock markets, Japan and the UK are the cheapest, while the US looks the most expensive (it’s outperformed and everyone loves it, he notes).
Given these low projected returns, and central banks throwing around money, should we look to alternative assets?
Unfortunately most of these assets are not cheap, as it’s getting a bit late in the game. He sees few bargains in the commodity complex, for example.
There is one asset class that he believes is “extraordinarily cheap” – US residential real estate. He doesn’t believe there is any developed country in the world with real estate as cheap. And mortgage rates are incredibly low.
His cheery summary on investment returns to come:
“It’s a low return world and there’s not much that’s cheap out there, other than the stuff that scares you to death. Too bad.”
US Fiscal Cliff and Entitlement Reform (or Lack Thereof)
If the fiscal cliff comes to pass, Barnes believes whatever damage goes through will get reversed in January when the new elected officials are in place.
He does fear, though, that the American economy is stuck at a 2 – 2.5% growth rate. And adds that one way or another the US will be forced to deal with entitlement reform because the markets will force it.
He thinks this is likely to be the next financial crisis coming our way – likely to occur when the markets turn their attention past Europe, and towards the US fiscal situation. (Barnes quipped that markets appear to have ADD these days, where they can only focus on one thing at a time).
China Has Issues, but OK Long Term
China’s issues are well known – its banks, its transition from an export-driven economy, and so on.
But, Barnes points out that China is still a poor country that is plugging up the development curve. And it still needs a lot more infrastructure than it’s got. So he believes the long-term direction of change is upwards.
Though you can’t trust Chinese data, he assumes the Chinese government knows what’s actually going on. And unlike much of the West, they have a lot of policy flexibility available – to cut rates, and/or pump money in.
He sees China easing aggressively if growth slows more than they want (as in, below their stated 7.5% growth target).
The Fed’s Firing Blanks
“The Fed is done – in terms of its ability to have any impact. They are firing blanks,” Barnes says. “What really ails the economy is outside the scope of monetary policy.”
Pumping in more money could pump up the stock market, but it would sag again if the economy didn’t respond. And the level of interest rates is obviously not the issue.
“They will keep doing stuff – and they will keep firing blanks.” Because they need to look busy, he says.
Europe’s Rich Uncle and Family of Losers
The EU never fit together, as it never hit what Barnes refers to as the “optimal currency zone”. The hope was they’d become more like each other over time, which never really happened.
To give up on the euro at this point, though, is to give up the post-WWII vision of an integrated Europe.
The problem with Greece leaving is that you still haven’t solved Italy, Spain, or Portugal. So in the event that Greece dropped out, they’d have to draw a huge line in the sand in front of Portugal.
At current borrowing rates, Italy and Spain are insolvent. We won’t know if the euro can be saved over the long haul for years, and it will probably take another market rout to force policy makers to take the next step.
Germany could actually be the one that leaves, he admits – but that defeats the whole political dream. It’d only happen after they’ve exhausted all other options.
“Germany is like the Rich Uncle with the extended family of losers,” he aptly concludes.
A big hat tip and thank you to Contrary Investing friend and legend, Jonathan Lederer, for organizing this event, and allowing me to crash for free!
Martin Barnes, BCA Chief Economist, writes BCA Special Reports based on his in-depth research of the global financial markets, and this year, has been on an international speaking tour for BCA. Mr. Barnes joined BCA Research in 1987. Since 1993, he has written the monthly Bank Credit Analyst that provides clients with forecasts and analysis of trends in major investment markets, with particular emphasis on equities, business conditions, inflationary trends, interest rates, gold and the Dollar. Today, Mr. Barnes still contributes to the Bank Credit Analyst with Peter Berezin, Managing Editor. He also writes a number of special reports and publications for our firm as Chief Economist and speaks to investors at special events and conferences. Prior to joining the firm, Mr. Barnes spent ten years as Chief International Economist with a major U.K. securities firm and five years as an economist with British Petroleum.
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