The US dollar and bond markets will continue to benefit from a flight to quality trade keeping rates much lower than expected by many. However, this is not because we see the US economy performing exceptionally well; rather, just less poorly than most. We also see the beginning of the end of the bull market in stocks which began in 2009. Importantly, we see a very negative long term trend for equities in general over the next decade.
Let’s begin with a look at some important historical data. Stock returns over the long-term have averaged about 6.5% for US investors. I believe that most investors would be very surprised at this number. This takes into account the last 115 years.1
Note that the past ten and 20 year numbers are in line or slightly below the long term averages. However, the past five years have shown a return significantly in excess of this historical average for the U.S.2
Another observation that is important for Canadian investors. The past five and ten year periods encompass the highest average oil prices in history, yet equity investors have made almost no money investing in the Canadian stock market. Is it any wonder that the best Canadian institutional investors have but token allocations to Canadian stocks and are instead turning to the US and other markets?
We believe regression to the mean is law in investing. Turing back to US equity markets, on the back of the outperformance for the past five years, we believe that returns over the next few years are likely to be well below historical averages of 6.5%. A brief look at beginning valuations tells us why we believe this to be the case.3
We are now at valuation levels seen only twice before: once before the Great Depression in 1930 and the second spiking in 2000 after the internet bubble and then remaining elevated from there leading up to the financial crisis of 2008. While valuations are key, we all understand that things can continue to be over-valued or become more over-valued for long periods of time, but at some point, markets will wake up to the reality, and often over-correct. As we sit today, we believe that holding equities is not investing, but speculation. What is well known by investors today is that both revenue and earnings growth is now effectively non-existent. So much of the equity returns we have seen over this period have been nothing but increasing valuations based on money flow algorithms, which in turn were triggered by very low interest rates. Interestingly, the valuation explosion has happened at a time when corporate profits as a percent of GDP have been at their all-time high.4
We have had a long run of productivity (jobs being replaced by machines or outsourced to low wage jurisdictions/countries) and had a huge dividend from lower interest rates (debt being refinanced at lower rates) but all good things come to an end. We concur with recent research from Morgan Stanley that suggests labor will begin to take a larger share of the cost pie, hurting profitability going forward. Labor forces are shrinking across the globe as population growth in both developed and key emerging economies slows. Nowhere is this more evident than here in the U.S.5
With unemployment rates falling below 5%, it is a matter of time before wage pressures begin to build. And with the economy firmly pointed in the direction of services (i.e. healthcare), the ability to do more with less reaches its limits. In summary, in the face of sky high valuations, we believe a lack of revenue growth and shrinking profit margins will all play a role on limiting future equity returns.
We believe US equity markets are ripe for a fall in 2016. Valuations remain elevated in the face of no revenue or earnings growth. Another factor at play will be profit margins (unsustainably high), which will likely suffer from increasing labor rates (including higher minimum wage rates) further pressuring earnings. However, we believe the high yield market offers investors an attractive alternative to equities.
Outside of energy and commodities, we view the high yield debt market as undervalued given the fundamental backdrop relative to the yield and price discounts currently available. Leverage ratios are stable and interest coverage ratios have been improving. Additionally, defaults are expected to remain below historical averages outside of the energy and commodity sectors.6 We believe the high yield market, often a leading indicator, has already felt its pain due to the economic environment and is now starting to stabilize, offering what we see as a compelling opportunity. However, we feel active management is essential in this market as investors need the ability to avoid certain securities/sectors and embrace others, rather than following a broad index. If you need any more evidence of the risks we see for these passive, index-tracking products, especially as it relates to energy, just look to iShares planning to launch a high yield ETF that excludes energy credits. We don’t think this sounds good for the hundreds of millions of dollars in existing high yield index-tracking products. Active management matters.
We believe the high yield bond and loan market offers income focused investors a way to generate a steady income stream and the potential for capital appreciation to help drive long-term returns. We see this as an attractive alternative to equities, where we expect the pain is in the beginning stages. To read more about our thoughts on the outlook for equities, and alternatively the opportunity we see in the high yield market, see our piece, “Zero Sum Game.”
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