Most markets rallied in January after a miserable 2022, but few look attractive. With sentiment souring around the world, the topic of where to invest is worth a contrarian examination.
Of the 16 asset classes tracked by Research Affiliates, only one, commodities, was up last year, according to the firm’s co-founder, Rob Arnott. Like many others, he believes U.S. equities remain overvalued. Yet this nation remains an island of stability beset only by spy balloons, UFOs and internal squabbles.
In contrast, Europe has a full-scale war on its border, Asian nations are trying to determine what an ambitious China’s next move will be, while South America and Africa have their own set of problems. One reason America remains the world’s safest place to invest is geographic isolation. Moreover, the possibility of a war breaking out in Canada or Mexico or the chance of China establishing military operations on a collection of rocks off Catalina Island or Martha’s Vineyard seems remote. But valuations matter, and it’s now clear U.S. stocks were severely overpriced 14 months ago.
The Worst Didn’t Happen
It’s worth recalling that the consensus in early 2022 was that the U.S. would have a mild recession and Europe could suffer a near-depression. So far, neither has happened.
“Last fall, the fear factor was getting pretty intense,” Arnott says. “We never got to peak fear in the U.S., but Europe and emerging markets did.”
The idea of thousands of Germans freezing to death was seen as a real possibility, he recalls. But while Europe’s economy is hardly paradise (which everyone has known for decades), so far it has managed to sidestep a recession.
Despite a strong rebound in value stocks and the EAFE and emerging market indexes since last fall, Arnott notes that value stocks in many markets remain in their cheapest historical quintile. In his view, a broadly diversified portfolio that underweights U.S. growth equities presents a plethora of interesting opportunities.
Despite renewed interest in the bond market after a disastrous 2022, he observes many sectors of the U.S. bond universe still sport negative real yields. Most emerging market debt offers higher yield than U.S. junk bonds. “A basket of non-U.S. liquid alternatives is likely to have a stupendous decade,” he predicts.
Value investors like to find glaring gaps between mainstream perception and reality. Arnott is proud of Research Affiliates’ call almost two years ago that U.K. stocks could be “the buy of the decade,” reasoning that economies and equity markets are not nearly as correlated as many investors believe.
Since then, Brexit has exacted a terrible toll on England’s economy, particularly the supply side, at precisely the same time the post-pandemic reopening disrupted global supply chains everywhere. Yet in 2022 when the U.K. had three prime ministers in as many months, its stocks beat their U.S., European, Japanese and Chinese counterparts.
People forget that when 19th century financier Nathan Rothschild said “buy when there is blood in the streets,” he qualified the remark with “even when the blood is your own,” Arnott explains.
But when it comes to the world’s most recent calamity, Covid-19, the world is managing to move on. “Covid hasn’t left us, but we’ve left Covid,” Arnott says.
His advocacy of broad diversification in uncertain times coincides with Michael Cuggino’s philosophy. Cuggino, the president and portfolio manager of the Permanent Portfolio Family of Funds, says, “Unless you were long energy and short everything else, you were probably negative last year.”
But Cuggino also thinks 2022’s gloom may be overdone. Early this year, a lot of economic data points prompted “people to question the recession call.” Unemployment may be a lagging indicator, but he notes it’s difficult “to have a deep recession when this many people are working.”
However, people still don’t know what the impact will be from QT (quantitative tightening) or central bank interest hikes, which can take as long as 18 months to influence economic decisions.
Besides the market’s swing from growth to value, Cuggino sees changes undermining several decades of developing conventional wisdom. “The Fed has been a backstop [for stocks] for 35 years, and investors have a bias to believing that’s what’s going to happen when push comes to shove,” he says.
He notes that the concept of “TINA” (there is no alternative to stocks) is now under question—and that there have been significant outflows from U.S. equities into foreign vehicles in recent months. But if the Fed is forced to maintain higher interest rates for longer than many market participants expect, investors could continue to move into bonds. Moreover, the macro backdrop with the reopening of China favors commodities and materials.
If there is any consensus, it’s that this decade will look very different from the last. Exactly how isn’t clear, but some signals are appearing.
Tangible Assets Are Ascendant
Every cycle experiences its own misallocation of capital. In the 2009-2020 era, intangible assets like patents got elevated to extreme levels, observes Rob Almeida, global investment strategist at MFS Investment Management. With a very low cost of capital, businesses could invest “in IT moon shots.” Today, Alphabet shareholders are wondering whatever happened to its driverless vehicle, Waymo, and demanding accountability for so-called “science projects.”
The U.S. economy also experienced a massive expansion of profit margins coupled with very weak GDP growth in the last decade. “Profits grew 250% to 275%, stocks were up two to three times, and GDP grew 2%,” Almeida says. “Too much capital went into non-physical assets. You can do that in a low interest-rate world. Now we have a physical world we’ve outgrown.”
Forty years ago, about 80% of U.S. capital expenditures were devoted to physical infrastructure, Almeida says. Today that number has nearly been halved, with much of it going to software and data analytics.
The reversal in capital spending priorities is just getting started. Since 2021, U.S. companies have made more than $300 billion in capital expenditures, and Almeida expects it to continue.
Until recently, companies that employed lots of workers found themselves in the driver’s seat, as employees felt lucky to have jobs after the 2008 financial crisis. Businesses “could extract value from their stakeholders,” ranging from workers to communities that were eager to have an employment and tax base.
Corporations have until now been able to invest in light intangible assets and dictate what they paid for wages, which meant they could realize dramatic expansions in their profit margins to the 12% to 13% area, Almeida argues. Now, he adds, “the stakeholders are coming for their share.”
As GMO co-founder Jeremy Grantham has maintained, demographics drive global labor markets, and aging populations are likely to exert a favorable impact on wages and a deleterious effect on profit margins. It’s not just labor costs.
Almeida believes the era of falling taxes is probably over. Demands for more equality, labor diversity and fewer carbon emissions may be a positive development, butthese goals will have their own attendant costs. That’s why a higher growth economy with lower profit margins and shareholder returns may be dawning.
Meanwhile, it’s become more expensive for companies to finance tangible infrastructure when interest rates are soaring. Perma-bulls are unlikely to be encouraged when they see what happens to the corporate profits of businesses that must refinance. Investors looking to avoid downsides will likely want to avoid marginal businesses that have to refinance 3% or 4% debt at 8% in the next few years.
Science and engineering are cumulative, but finance is cyclical, Almeida explains.