27 Apr European & EM stocks set to outperform the US market
Part One
We have had a very negative view of US equities relative to European and Emerging Market (EM) equities since long before covid19 became a factor. Our reasoning has been simple. In the shorter-term valuations are a poor predictor of future returns but over the longer term they are by far the most important factor. Valuations have been and still are very high in the US relative to Europe and Emerging Markets.
Out of 40 countries, the US ranks as the second most expensive country. It is by far the most expensive in developed markets.
Reasons why we believe US indices will under-perform Europe and EM Equities.
- US buybacks are finished!
US companies have by far been the most aggressive borrowers during the last decade. Low interest rates have allowed big US corporates to borrow cheaply (via corporate bond issuance). In a vast majority of cases they took the proceeds of that corporate bond issuance and used it to buy back stock, which synthetically pushed earnings per share higher.
So, you issue cheap debt to fund stock buybacks, which synthetically drives earnings per share higher but now you have Frankenstein on the balance sheet (Loads of debt to pay back).
When the cycle changes (It has changed) and earnings per share begin to decline, well if you do not have positive free cash flow, you need to either borrow more money (issue more corporate bonds), which has the effect of taking from Peter to pay Paul….Or, you have to issue new stock. If you issue new debt to pay back the old debt, in this environment it will be more costly for you. But if you issue new stock at a time when earnings are already in decline, it becomes heavily dilutive to earnings per share. You had a period where you got the Yin; borrow cheap to fund stock buybacks. Now you get the Yang, you issue new stock to pay back bond holders which kills the stock price.
The Yin drove foreign capital into the US. The Yang will drive foreign capital out of US Equities. The genie is out of the bottle on buybacks. We believe we will soon begin to see capital flight out of the US and into Europe and EM soon. The fact that the US is behind most of Europe in terms of dealing with the covid19 crisis, could accelerate the process.
- Capital flight out of the US will be accelerated by Dollar weakness.
Driving forces behind Dollar strength over the last few years have differed. The reason for Dollar strength now is different than it was before the covid19 crisis. Before the covid19 crisis, interest rates in the US were significantly higher than they were in most other Developed nations. This caused many yield starved banks and investment funds outside the US to buy Dollars with their native currency and then buy those higher yielding US government bonds. It worked well for a time as the Dollar went up in value and investors enjoyed higher yields. That game is over now! The interest rate spread between the US and other Developed markets has collapsed on the back of US Federal Reserve interest rate cuts. The incentive for foreign money to hold US treasury bonds is gone!
Remember the Dollar is the reserve currency of the world. A big drop in the Dollar would be inflationary. I know it sounds crazy to think we could see inflation when we’ve just seen the biggest demand shock in history, but paper money yields nothing in the Developed World and Central Banks are printing tons of it right now. Again, we’ve seen 5X the amount of stimulus we got in all of the Global Financial Crisis, in the last few weeks! The balance sheet at the Federal Reserve is currently growing at an annualised rate of $34 Trillion. So, you have a crazy amount of money being printed and there is no incentive to hold it (yield). You have this environment where you have finite amount of supply of assets (particularly hard assets) valued in infinitely printable money. The money printing is a Central Bank factor. We haven’t even talked about the Fiscal Stimulus that is happening in Governments around the world! Germany, the poster child of prudence, just pretty much threw all their budget constraints out the window! We see this as highly inflationary going forward.
That’s going to be really good for companies who have decent balance sheets and bad for companies that have a lot of debt to pay back in the coming years. The US is the poster child in that regard.
David Flynn & Peter Brown are Directors of Baggot Investment Partners
For more information contact (dflynn@baggot.ie / pbrown@baggot.ie)
Part Two
Future Investment strategies we really like.
For Equities our focus is in Europe and Emerging Markets (EM). We like companies in commodity focused areas, particularly mining and agriculture. Energy is cheap but it is pretty pointless to think about until we are driving and flying again.
We see trouble down the road for businesses that have high debt/equity levels. However, those who are cash rich, have high interest cover and throw off free-cash-flow will take market share and grow in time.
We are very bullish on precious metals over the coming years. If you give me no yield on cash and you’re going to print tons of cash, then I will hold precious metals. I have a hunch this could be the best performing asset class over the next couple years.
Developed market bond investors have to accept lower returns. There is very little yield on offer right now that is safe. Emerging Market Bonds offer the best relative returns, but they are somewhat riskier so make up a smaller percentage of a portfolio.
We’ve spoken in the past about Social Housing, but we think this is an exceptional time to consider it. We see that as a suitable alternative investment to Irish Government Bonds.
GOLD
A Gold price of $2400 looks entirely likely over the next couple years. There is just no incentive for people with cash to hold Government Bonds that yield nothing when you can hold Gold.
At the beginning of a crisis Gold tends to do better than Silver, but typically once stimulus gets underway Silver tends to outperform Gold. Gold will protect purchasing power more so in disinflationary or deflationary environments, but in Inflationary environments, Silver is always best.
Although we have a bullish view on Gold, we would add that at current price levels around $1700, it is possible to see a drop of 15% off recent highs and still be in a bull market.
SILVER
Gold and silver are highly correlated. They tend to move in the same direction over long periods of time, but to varying degrees. The ratio of Gold/Silver which tells us how many ounces of Silver you can buy with one ounce of Gold is 112. Silver has never been this cheap relative to Gold!
After the Global Financial Crisis in 2008, we saw an incredible rally in Gold and Silver until they topped out in 2011. During that period the ratio dropped from around 82 to nearly 35…. meaning Silver more than doubled the performance of Gold during that period. We see that scenario as highly likely in the coming years, so while we are bullish on Gold, we are very bullish on Silver. We see a ratio of 65 ounces to one ounce of Gold as fair value. We see Gold at $2400. Divide our projected Gold price by 65 ounces (where we see fair value) and you get a price $36.92 per ounce for Silver. Even if Gold were to stay at current levels of $1640, if we do the same math we get a Silver price of $25.23 per ounce.
We like Gold Miners and Silver Miners as well. We think they are very historically cheap relative to the precious metals that they mine but one issue we have with miners in the near term is that a lot of mines are shut down because of covid19. All the workers are at home riding this storm out like the rest of us. This means miners are probably looking at a bad quarter for earnings. Further that issue tightens demand for precious metals because there’s not much new supply coming to market from the miners. We think that benefits the precious metals holders in the near term, but once the covid19 curve begins to flatten, it should be overwhelmingly bullish for miners.
David Flynn & Peter Brown are Directors of Baggot Investment Partners
For more information contact (dflynn@baggot.ie / pbrown@baggot.ie)