Markets continue to climb, reaching new heights and setting records seemingly daily.
But there are still risks for investors in the form of high valuations, soaring debt levels, and geopolitic uncertainty.
Recently, at the UBS CIO Forum in New York City, Business Insider caught up with Matt McLennan, head of the global value team at First Eagle Investment Management, to talk about market risks.
McLennan manages the $US55 billion First Eagle Global Value fund with Kimball Brooker. The fund is up 8.5% year to date.
Matt Turner: I wanted to talk to you about your views on the stock market because you are a bit cautious about where we are right now. More cautious maybe than the rest of Wall Street. So I just wanted you to talk through why it is that you’re taking that stance.
Matt McLennan: Well, at First Eagle, we acknowledge that we don’t have a crystal ball that lets us predict the next 12 months or 18 months with specificity. But what I will say in general is that there is an absence of obvious bargains bottom up. There are some sectors and companies here and there where we see opportunities, but the market itself is not presenting a lot of bargains, and we are primarily bottom-up investors.
When we zoom out and we look at the macro picture, we see a market that has really rerated dramatically in terms of valuation terms. The market’s gone form less than 10 times trailing peak earnings in 2009 to more than 20 times trailing peak earnings today. That’s coincided with other measures of risk and asset pricing also inflating. Credit spreads have come down. Implied volatility has come down, and the business cycle has improved. You know, unemployment’s gone from 10% to just over 4%, so a lot that can go right has gone right.
And yet we sit here today with more debt than we had at the end of 2007. Globally, household plus corporate plus sovereign debt to GDP is actually higher than it was in 2007. We have a situation where there’s financial-structure vulnerability, there’s arguably geopolitical risks, and valuations are not that attractive. That just makes it harder to put money to work one business at a time, and, as a result, as a residual of that disciplined approach, our cash levels have built in the portfolio.
Turner: You mentioned the level of debt. How big a risk does that pose, and why is that such a problem?
McLennan: It’s interesting. It depends on the form of the debt. In the late ’90s, we had a lot of issuance of corporate debt, and, if you recall, we had the blow-up of WorldCom and Enron and a high-yield crisis. And then in the mid-2000s the excess in debt was in the residential real-estate sector, and we had a blowout in spreads, and real-estate prices came down, and we had the global financial crisis.
Today, by and large, the excess debt is in the sovereign sector, which is very different because sovereigns can do something that corporates and individuals can’t do: They can print money.
So the consequence of excessive sovereign debt has been very low interest rates, and if you have interest rates that are low relative to the rate of growth of the economy, you can try to deleverage that way, but we’ve yet to see the deleveraging.
We could be in a situation for some time where even though we may see cyclical rises in interest rates, structural rates are quite low, and it’s going to be hard for investors to get a good return on their capital, whether it’s low interest rates or high PE ratios. The expected returns that investors can get looking out over the next decade are low, and yet the risks may be above average. So that’s a tough environment for investors.
Turner: During one of the panels at this forum, I saw a survey about return expectations, and I think the most popular vote was somewhere between 4% and 6%. Where do you stand on that? Or how did you vote?
McLennan: I didn’t get to vote, which, you know, I’m used to. [Editor’s note: McLennan is Australian.] We don’t have a short-term view on returns, but I would say that if you look at long-term interest rates in the US, bond yields are at more than 2%. The short end of the curve is lower. If you’re looking at sovereign assets, obviously returns are below that.
If we look at equities, many businesses are not priced for much more than mid-single-digit long-term returns given the starting valuations. So a passive, balanced portfolio could even have mid-to-low single-digit returns, and, in real terms, that’s not much, which raises the risk that, at some point, people may need to save more.
We’ve brought a lot of growth forward through easy policy, and now that the policy environment is tightening with interest rates going up, the Fed talking about shrinking its balance sheet, perhaps we see after the 18th Party Congress in China a return to the focus on restructuring.
The policy environment could become trickier at a time of lower expected returns. We think it’s just a time to be realistic in your expectations and not get too carried away based on the good returns in the rear-view mirror.
It’s rarely a good idea to drive your car looking in the rear-view mirror.
Turner: You mentioned China and there being a policy risk around the world in the US and elsewhere. How do you see that playing out, particularly with regard to China?
McLennan: The problem that we see with debt — for example, in the United States — is not unique to the United States. In fact, across the developed world, we’ve seen debt ratios higher than they were in 2007. And likewise China.
China is very important to understand, because if you went back in time to 15 or 20 years ago, Chinese money supply and Chinese fixed-capital investment was a fraction of the United States’.
Over the last 15 years, through an epic credit boom in China, the money supply has grown to more than the US in US dollar terms and fixed-capital investment had grown to more than the US. So China was the key marginal driver of global growth over the last 10 to 15 years and yet, now it has imbalances as a result of that growth.
As I mentioned, debt levels are very high in China for an emerging economy at a time when many industries are struggling for profitability. The currency, which was undervalued 10 or 15 years ago, which was a great source of growth, is now more fully valued. It may even be overvalued.
And so China faces a host of different pressures and what we may see in China is that the government try to buffer that pressure. So you could see the emergence of sovereign risk in China as they try to find a path through this adjustment.
Turner: What does that look like, that sovereign risk for China? What does that mean?
McLennan: Well, it could just mean that at some point they run larger deficits.
Some of the excess debt that’s in the SOE’s may implicitly be transferred to the sovereign sector like it was in the Western world during the global financial crisis. When the household sector de-levered in the US, it was offset by growth in government debt in the United States. And we saw that pattern elsewhere in the world. We may see a similar pattern in China.
But beyond debt dynamics, we’ve also seen the emergence of a multi-polar geopolitical world. You can’t have the awakening of an economy as large as China without geopolitical ripples.
As we’ve moved from, what was a unipolar system at the end of the 1990s when the Washington consensus reigned, to what is a multi-polar world, the system is disrupted. And we see that in episodic windows of crisis.
Whether that is with North Korea, or whether it’s in the South China Seas, or whether it’s in geopolitical initiatives of the Chinese such as the Belt and Road initiative linking China through the Eurasian heartland to the Middle East.
I think the world has become a lot more complicated.
Turner: And to bring this back to markets, it seems that markets have not reflected the added complications that we see in the world right now.
McLennan: No, right now if you look at risk markets, they’re basically pricing the Goldilocks world. Low and contained inflation, decent earnings, and low interest rates being the rationale for low earnings yields or high PE ratios.
Having said that, if you step back from it and you reflect on the fact that low interest rates may be a symptom of excessive debt, then maybe you could make an argument that PE ratios shouldn’t be so high. If there’s too much debt in the world and equities are a residual claim on the world’s assets, maybe there should be somewhat of a risk premium reflected. And then you lay on top of that the geopolitical risk.
We think it’s a challenging environment to be an absolute return investor. If you want a margin of safety in price, it’s hard to find in this world.
And if you look at our portfolios, we are primarily business owners. Seventy per cent of the portfolio is in good businesses that we bought at good prices, but today we have upwards of 20% in cash and we have 11% to 12% in gold as a potential hedge. That cash and gold position is pretty large relative to our history.
Turner: Has that position in gold changed recently? Have you been buyers of late?
McLennan: Over the last couple of years, we’ve been buyers on the weakness of gold. In a world where manmade defensive assets are not yielding much, nature’s defensive asset has been very out of favour. As a source of potential ballast in the portfolio, we’ve added to it on weakness. And if we hadn’t, it would have become a smaller position of our portfolio while the price of that potential hedge had gone down, which doesn’t make sense to us.
We’ve been happy to add modestly to our goal, but if you look at the long-term history, our portfolio’s goal has been around 10% of the portfolio plus or minus a few per cent. We are a little on the high side today.
Turner: And with regards to 70% that you have still in good businesses, where are the opportunities? You said at the outset it’s getting harder to find them but do you see spots of opportunity?
McLennan: There are always spots of opportunity when your focus is global and you look across all industries, there’s always going to be some part of the market where you can put some capital to work.
Typically, for us, that involves looking for companies or industries that have been through their own bear market. If the market as a whole is a seasoned bull market, you have to kind of look for bear markets underneath the surface.
One area, for example, where we have put some money to work over the last year would be the energy area. Obviously, it’s been very washed out and everyone’s been focused on the negatives around energy, but the energy price has been at a level that is below what is required to make the best producers profitable and to make the best oil services companies thrive. So, ultimately, companies have been underinvesting.
This could come back to bite in a few years time and meanwhile, sometimes the cure for low oil prices is low prices themselves. Low prices have been stimulating demand growth. We’ve used this window of uncertainty to selectively add in that area.
Other than that, it’s very idiosyncratic. It’s very company by company and we’ll always be finding opportunities, but if we look at the market as a whole, it’s not a market with abundant opportunity.
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