«I don’t trust this rally»

Ben Inker, head of the Asset Allocation team at Boston-based asset manager GMO, likes emerging market equities. US-stocks are still overvalued.

Before the crash, US-stocks were «very substantially overvalued», now they are «slightly less overvalued». That’s how Ben Inker puts it. The head of the Asset Allocation team at Boston-based value manager GMO, finds emerging markets more attractive. Despite the challenges of the pandemic, he sees opportunities in Taiwan and South Africa.

Mr. Inker, the S&P 500 (SP500 3294.62 0.72%) has recovered half of its 33% drop in only a few weeks. Was the fall overdone, or is the recovery premature?
On the one hand, markets have a very strong tendency to overestimate the importance of acute near-term events. The market falls a lot in a recession. Usually, those recessions don’t matter much for fair values. So the market was irrational to fall in the first place, but it is a very natural response. So maybe the market didn’t need to drop all that much.

And on the other hand?
Before the crash, the S&P 500 was priced for a very nice world. For high-profit margins, a stable economy, and no disruptions. If there was a market that should have fallen materially, it was the US. I don’t trust this rally, even though the underlying fair value of the US stock market didn’t drop by much. Before its fall, it was very substantially overvalued.

And now?
The S&P 500 is slightly less overvalued than it was before. Our estimate of the fair value of the S&P is somewhere around 2000 or below.

How much did the fair value fall due to the current downturn?
The current downturn will be a very bad recession. I hope it will be a short recession, but there is uncertainty about the length of the slowdown. The good thing about equities is that they are long-duration assets. They’re not valued on what this year’s cash flow is going to be, but on the present value of cash flows going out 10, 20, or 50 years. The more distant the cash flow the less the current crisis should be expected to impact it. There’s a lot of uncertainty about what 2020 and what 2021 are going to look like. But as we think about 2025 and 2032, there’s less reason to believe the world will be significantly dislocated.

About Ben Inker

Ben Inker has spent his entire career with Boston-based asset manager GMO, which currently manages $60 billion in assets. After studying economics at Yale University, he joined the company in 1992. Inker (49) has been an equity analyst, portfolio manager, and co-head of International Quantitative Equities. Today, he is head of the Asset Allocation team, which is responsible for a core strategy of the firm. The strategy is based on the expected return of asset classes over the next seven years.

How much has the pandemic affected the fair value of equity?
Some companies are going to go bankrupt, other companies are not going to go bankrupt but are going to have to dilute shareholders via issuing new shares. Only a handful of companies will benefit from the pandemic. For most companies, fair value has fallen between 5 and 15%. This is less than by what stocks of most companies have fallen. Despite the fall in fair value, the vast majority of equities are cheaper now than they were at the end of February.

What about the broad market?
My current guess is that the fair value of the S&P 500 has been reduced by 6%, European stocks by 7,5% and emerging markets by 8 to 9%. Everything outside of the US is cheaper than the US.

Are any stock markets fairly valued?
Emerging markets are fair valued. They were pricing in a pretty scary world already before the crisis. Now it is a scary world. If you were pricing in a scary world, maybe you didn’t need to change that much. We strip out banks and resource companies in our valuation because, for those two groups, traditional valuation metrics can be misleading. Even without these two sectors, which have been hit quite hard and look very cheap now, emerging markets look to be at fair value.

What about European stocks?
Europe and Japan look cheaper than the US. They’re not cheap relative to their history, but they are priced to give a decent risk premium relative to low-risk assets.

What do you mean?
Everywhere, where low-risk assets used to have some return, those expected returns have fallen significantly. That is not such a big deal in continental Europe where yields were already approximately zero, even negative in some places. But looking at the average return across low-risk assets around the world, it has fallen considerably.

Where do you find value?
There’s cheapness in a lot of places. There are markets that have gotten hit very hard, like Brazil or Russia, where the fall was 40 or 50%. That is a very big drop even if you think there’s going to be very substantial damage to the fair value of companies. There’s a lot of scope to give a haircut to a fair value and still leaving you pretty cheap.

What about the danger of Covid-19 in these places?
We look at how well-positioned countries are to deal with Covid-19. China has shown an ability to control this disease in a way that nobody else has duplicated – possibly because nobody else is willing to put up with the personal liberty trade-offs involved. Korea and Taiwan also score pretty well. Together with China, these three countries are in aggregate about 58% of the MSCI Emerging Market Index.

China outperformed other emerging markets over the last months. Is it still attractive?
The valuations are getting more compelling in other countries relative to China. I still do like Taiwan or Russia. I have been slowly rotating the portfolio towards some countries that have gotten hit badly. Even if they are less well prepared for dealing with the crisis from a healthcare perspective. Places like South Africa and Latin America.

Has the current strength of the Dollar any negative impact on emerging markets?
The strong US dollar causes a short-term funding problem. Because emerging markets tend to have debt denominated in Dollar and don’t have natural Dollar assets. In the longer term, when emerging markets currencies are cheap, emerging markets tend to do very well because these countries become very competitive. Over time this leads to very strong earnings growth. The fall in emerging markets currencies is a good long-term thing.

How do you rate the handling of the crisis in the US?
The good news about the US is we’re throwing a lot of money at the problem. The bad news is we’re not doing a great job of throwing that money in the right places at the right time.

What will be the consequence?
I worry that the outcome is much better for politically-connected companies than for the most deserving companies. One impact that we’re already seeing is that there is more damage to the employment situation than there theoretically needs to be. In a typical recession, you want fluidity in the job market. You want the bad companies to disappear and to be replaced with new, more efficient companies.

Is this different now?
This is a very different economic crisis. You would want the economy – whenever we can come out of our houses and go back to work again – in more or less the same state as it was at the end of 2019. Europe is doing that in a much more concerted fashion than the US. And that’s going to make it harder for the US to get the economy back to normal.

Were the actions taken by the Federal Reserve necessary?
The Fed’s actions were necessary. We have to care about the financial markets because it’s an important transmission mechanism to get money flowing to the right place. But it is the economy and incomes that are of primary importance here, and to date, the US has not yet pulled that one off.

Do you still see any areas in the credit market – or the financial market in general – with a worrisome level of stress?
Things are not back to normal in fixed income by any means. Spreads are high, liquidity is thin. In the highly levered area of credit, below the fallen angels that the Fed is going to support, things are awfully tough. They’re not abnormally tough. And they should be tough. If you were highly levered going into this, chances are you have to do some kind of restructuring. Restructuring is messy and that seldom happens smoothly even when liquidity is widely available.

Is the huge amount of corporate debt a problem?
It was a much bigger worry before the Fed announced to support fallen angels. That’s a big deal because the BBB universe is vast compared to the high-yield universe, and lots of those companies will deserve to get downgraded. We’re going to be in a slightly weird situation, though, because if you get downgraded below BB, the Fed no longer will support you.

That will put a lot of pressure on rating agencies.
I don’t know how this pressure is going to play out, but there is going to be a big deal for a company that gets downgraded to BB not to get downgraded further to single B. That could be the difference between survival or not. That puts the rating agencies in an awkward position.

Is the Fed creating a moral hazard?
The moral hazard, in this case, is a lot less bad than it usually is. Much of what’s going on in the economy today is an inherently exogenous shock. This is not happening because of bad things that companies did. In the financial crisis, a lot of companies did a lot of bad stuff, and the moral hazard was a big deal, and frankly, I’m not sure we threaded that needle perfectly. In this case, you want to err on the side of having less disruption if you can and try to make it very clear that this is a one-time thing due to a pandemic and you can rely on us when in a hundred and two years we have another pandemic that we will step in. But don’t depend on us to step in every time we have an economic downturn or a credit crunch.

Will there be a lasting consequence on the fair value of the stock market?
The only kind of event that has been utterly disastrous for the fair value of stock markets has been regime changes. For example when there was a communist revolution. That’s not good for the stock market. Hyperinflation is terrible, the massive physical destruction of industrial capacity associated with losing a major war and being overrun is pretty bad. But almost nothing else has left a lasting impact. Think about what’s going to happen here. The good news is, no productive capital is going to be destroyed. This is a disease only of people. Once we get through this, the economies will still be there, the factories will still be there, and the workers will still be there. There’s no reason to assume there will be a long-term impact on the return of capital.

Will the liquidity that is being pumped into the system lead to inflation?
We are performing a macroeconomic experiment of a type never seen before, and in principle, you would expect it to be an inflationary trigger. We are creating a huge amount of additional currency and whereas in the financial crisis back in 2008-2009 that liquidity got shoved into the banking system and never went into the real economy, now, we’re creating that money and we’re giving it out to people. We learned in economics class that this should lead to inflation. But everything we learned in economics class could not explain why we haven’t had any inflation in the developed world in the last 15 years.

Do you expect inflation to come back?
I don’t know. But we have to invest as if it is a meaningful possibility. That does mean that there are no risk-free assets. People are assuming that Treasuries and German Bunds and Swiss government bonds are all risk-free assets. They’re not protected against inflation. If inflation were to come, the returns on those bonds would be disastrously bad.

Do you expect the yields on treasuries to rise as well?
I don’t think the rates will necessarily go up. Every government on earth is going to be increasing its debt to a very significant degree. You can very easily imagine the government simply not letting bond yields go up. You could readily imagine significant financial repression where the government holds down bond yields. You get negative real interest rates and so negative real returns on bonds. It’s a long time before those bond yields are allowed to float in any meaningful way.