To All Clients and Friends of Berkeley Capital Partners,
We hope this communications finds you and family healthy and enjoying the first signs of spring. We’ll begin this month’s communication with a look at the out-performance of growth shares over the past 12 months and the outperformance of value shares for the first few months of 2021.
Interestingly, the energy sector remains the strongest sector this year – a little ironic given that sector was the worst performer during Trump’s presidency and thus far the best under Biden’s. We don’t interpret this to mean carbon will no longer be in environmental crosshairs – but it’s demise might be suspended a bit as the world economy continues its recovery.
In the remainder of this brief update we will focus on the opportunities for investment in equity markets outside the US. Lets start by taking a look at growth in Global GDP over the recent past.
GDP is the accumulated value of all finished goods and services produced annually. Over the past 25 years, Global GDP has grown more than six-fold from $12 trillion to $90 trillion on an annual basis. Some of the growth can be attributed to inflation – the remainder to increased demand for goods and services, in most, if not all, countries across the globe. Certainly demographics, modernization, education and technology have all played a part in this growth. The following chart tallies GDP in the top twenty countries.
As you might suspect, the US leads with only China looming as a candidate to out-produce any time soon as seen in the chart below.
Although the US is predicted to grow, if these projections prove accurate, the pace of growth will significantly trail the expected growth of several emerging markets – China, India, and Brazil in particular.
US investment interest in emerging markets is not new. The first attempts to bring those markets to the US investor were executed by Mark Mobius who was dubbed the “Pied Piper of emerging markets” in 1987. We think it fair to state that over the past decade, returns from emerging market equities have been less than sterling and particularly so when compared to US equities. Over the past ten years as we emerged from the Great Recession, the SPY ETF (tracks the S&P 500 Index) has outperformed the VWO ETF (tracks the Emerging Market Index) by about 9% annually. To be fair, emerging markets have indeed been keeping pace over the last three years.
Emerging markets and select developed non-US markets offer interesting alternatives to staying fully invested in what many consider overvalued US equities or raising cash. However, we remain cognizant of the investment risks as we venture outside of our borders. We must account for currency risk, opaque reporting, and political concerns. This is not to imply we don’t have these concerns domestically. We’re just slightly less concerned.
Warren Buffett developed an indicator which compares the total market cap of a country’s stock market to the company’s Gross Domestic Product. (GDP/ Total Market cap). “Probably the best single measure of where valuations stand at any given moment,“ writes Buffett. The following Chart provides a seventy-year record of the indicator.
Source: Visual Capitalist
According to the indicator, the US market has never been this overvalued. You can see from the chart that as of February 11, 2021, the ratio is over 200%. Buffett writes “If the ratio approaches 200%, you are playing with fire.”
Visual Capitalist provides an interesting look at some historical moments for the US stock market and the indicator when it is flashing either an over or undervalued signal.
Source: Visual Capitalist
We would caution that being undervalued or overvalued doesn’t ensure markets will adjust. Perhaps this time will be different and optimism and speculation will cause our stock market to now be permanently overvalued or at least expensive. As always…..Caveat Emptor!
We thought our readers might find it helpful to show this indicator for other countries we might consider as trading partners, competitors or both. The charts below graph total market cap and GDP for a group of countries which peak our interest.
Source: Guru Focus
Source: Guru Focus
For the purposes of this letter we will only discuss Brazil, Russia, India and China more commonly referred to as the BRIC’s. All four of these countries have Buffett ratios of less than 100%. Interestingly, if we consider the 2030 GDP guesstimates referred to in the chart earlier, and the possibility that market caps remain unchanged for the next decade (which we will discuss momentarily), the US market will remain expensive and the BRICs more attractive based on Buffett’s indicator.
We have written often of our appreciation for the analytical work of GMO and particularly the views of Jeremy Grantham. They maintain a seven-year return forecast for a number of market indexes measured in real returns (real returns are equal to realized returns minus inflation). This chart represents their current expectations.
7-year Asset Class Forecast
In full disclosure, GMO has been less than ebullient about the US equity markets for several years. As market rallies counter their expectations, their forecasts have suggested US equities are even more overvalued. Never-the-less, Grantham argues that in the short term, the higher an asset is bid up the more expected long term return trends should lower. As an example, one particular company grew revenues from $24.6 billion in 2019 to $31.5 billion in 2020 – a 28% increase in revenues. However this company’s stock price grew 700%! He would argue, and we would agree, the current share price overvalues this company and that quite probably much of the appreciation expected for the future has already been achieved. Though not to the same extreme, GMO is only predicting one asset class will enjoy positive seven-year returns, and that is – emerging value shares.
Please don’t interpret our presentation of GMO expectations to be gospel. We will default to Warren Buffett in stating we believe forecasting the future is best accomplished with fortune tellers not financiers. However, the Buffet axiom which proposes we “be fearful when others are greedy and greedy when others are fearful,“ is worth emphasizing. We use the GMO chart only to point out that we do agree that emerging markets are the least expensive asset class in an expensive neighborhood.
The following are data points that led to our decision to increase international equity exposure. Mind you, these are macro concerns which may very well hamper the health and confidence in the US dollar.
Central banks appear interested in using monetary tools to respond more to market weakness than economic weakness. 20% of all sovereign debt trades with negative yields. In the case of the US market, how many more dollars need to be created before it’s too many?
The US current deficit simply has no ceiling. As we write, the $1.9 trillion stimulus package is now a reality. It is being characterized as a COVID Relief Bill for which we will have to borrow to pay for every nickel (accumulated US debt is approaching $30 trillion). The $1.9 trillion represents about $6,000 per every US citizen. However, those eligible to get COVID relief only get $1,200. By our estimates, only 7% of the dollars are earmarked for actual COVID Relief.
Obviously the new Congress, just like its predecessors, shows little interest in addressing total US debt. Again we aske ourselves “When will too much be too much?!”
The political climate has changed dramatically since the election. The new government was elected, and we would expect the following could exert a negative impact on both growth and profitability: Higher corporate tax rates, higher capital gains taxes, higher minimum wages, free college, tuition loan forgiveness, higher traditional energy prices, higher regulatory costs, and quite probably higher interest rates will hamper corporate profit growth. And ultimately rational stock investors buy profits.
The chart below represents IMF expectation for GDP growth in 2021 and 2022.
Source: International Monetary Fund
Notice the expectations for emerging countries is higher than Global growth and the US is lower. Spain and France also have a rosier outlook. This is the same group that underperformed the US in 2020. The possibility of better growth and lower valuations (as we witnessed with value stocks) add to our conviction in looking for opportunities overseas.
As always we look forward to and appreciate your feedback.
Your Berkeley Capital Partners Team