In general, I ignore the spate of market predictions that experts issue at the start of each year. There are exceptions, and after reading Jason Hsu’s outlook for this year, I am pleased to recommend it to readers. Dr. Hsu is the Chief Investment Officer at global money management firm, Research Affiliates. I found his article both insightful and appropriately skeptical of all forecasts. How can you not appreciate a money manager who starts his prediction for the year ahead with John Galbraith’s quip that “the only function of economic forecasting is to make astrology look respectable”?
I am going to mention a few of the elements of Hsu’s outlooks and add some thoughts. Hsu first examines the drivers for bonds and then equities. I will follow this structure.
In the section on bonds, he starts by considering bonds in the developed markets (DM) vs. those in the emerging markets (EM) separately. He asserts that EM governments’ primary concern is managing inflation risks, while DM governments are focused on stimulating growth. While developed countries can force down their yields as the Fed has done, and still find buyers, this is not the case in emerging markets. Investors in emerging market bonds assess the risks of high inflation and, potentially, default at such a level that EM bonds currently yield far more than DM bonds. Hsu’s position is that EM bonds are under-valued relative to DM bonds, even in light of the additional risks associated with EM bonds.
Hsu makes a very interesting argument about the relative value of credit ratings to investors in government bonds. He asserts that the ratings agencies are too slow to adjust their ratings and thus have little value for investors looking at the future. In particular, he suggests that emerging market bonds are probably unfairly penalized vs. developed market bonds by the ratings agencies.
Overall, Hsu concludes that investors are likely to get a better deal with government bonds from emerging economies than developed ones. This is not, in truth, a shocking assertion. At the most basic level, bond investors are weighing three factors: yield, default risk, and interest rate / inflation risk. EM bonds tend to have higher default risk and higher inflation risk, as well as substantially higher yields, than developed market bonds. At some point, the yield spread is high enough that EM bonds are a better bet. With many DM government bonds yielding less than their local rate of inflation, it is not unreasonable to assert that DM bonds have moved to an unprofitable range.
Largely due to the very low yields on government bonds, Hsu foresees investors choosing corporate bonds as a better alternative. His thesis applies not only to investment-grade bonds but also—and perhaps even more strongly—to high-yield bonds. This is not a shocking position given the historically-low yields on government bonds. Investors shifting from DM government bonds are shifting from a pure bet on interest rates and inflation to instruments that have both default risk and interest rate risk. Hsu makes the argument that high-yield bonds (HYG and JNK are two representative ETFs), despite having fairly low yields compared to historical averages, look attractive on a relative basis. While bonds tend to decline in the face of rising rates, Hsu asserts that high-yield bonds tend to have a positive correlation to interest rates. This makes high-yield attractive as an inflation hedge. This attribute of high-yield bonds is due to the fact that much of their risk is default risk rather than interest rate risk. In general, I agree with this argument in favor of high-yield bonds, but the case was much more compelling back in 2011. Back then, I wrote about the fact that high-yield bonds provided a modest hedge against rising rates, but yields were above 8% (this was for HYG). Today, the yield on HYG is at 6.5%.
One area in which I wish that Mr. Hsu had expanded his argument is that of correlations. While it is clearly the case that government bond yields have unattractively-low yields, it is also true that government bonds have extraordinarily low correlations to equities. For this reason alone, they deserve some level of allocation. In other words, even if they have zero or even slightly negative returns net of inflation, government bonds provide a powerful risk offset to other asset classes. Precisely because we do not know what will happen in the future, maintaining an allocation to government bonds is valuable.
In the second part of Dr. Hsu’s outlook, the section that deals with equities, the focus is on earnings and dividends. In particular, he discusses price-to-earnings (P/E) and dividend yield calculations of the markets as ways to estimate whether the broad stock market is over-valued or under-valued. On the basis of these measures, U.S. equities, DM equities, and EM equities look fairly expensive as compared to the long historical record (he uses 1881-2012) and fairly cheap compared to recent history (he compares to 2005-2012). His use of eight years (2005-2012) for his ‘short-term’ period is pretty arbitrary, but we will take it at face value. On the basis of dividend yield and P/E, the overall market looks a bit expensive but the market as a whole seems to have converged on higher P/E levels in the last decade and more, which tends to make the current prices look more reasonable. He concludes that emerging markets and non-U.S. developed markets have higher expected returns than U.S. equities. Neither of these forecasts are much of a stretch.
Aside from current valuation of stocks, there is also the question of how fast future earnings will grow. While the prices reflect some assumption of discounted future earnings, this is the most uncertain part of valuation. Dr. Hsu suggests that global demographics, with DM countries going gray, suggest much slower economic growth in the U.S. and other developed markets and faster growth in developing economies. He believes that the markets are not fully reflecting this and other factors (mainly stronger household and government balance sheets) that favor more robust growth in emerging markets than in developed markets. While he argues these points succinctly, I certainly hope that most readers will have encountered these predictions previously.
In his summary, Dr. Hsu coins a phrase that I will certainly quote in the future: “forecasters use statistics as drunks use lampposts, for support rather than for illumination.” Be that as it may, he does a good job with the statistics in creating a case for 2013 and beyond. The good news is that we can use portfolio design to hedge many of these risks. Without having a great deal of confidence in any forecast, it makes sense to combine emerging market stocks and developed market stocks in a portfolio. Given that it is impossible to forecast with any confidence when interest rates will rise, some exposure to government bonds makes sense simply as a diversifier. While money managers need to get their directional bets correct, it is enough for investors to hedge their bets with exposure to many asset classes. To the extent that one wishes to express a belief with a portfolio tilt, Dr. Hsu’s outlook would be a reasonable basis upon which to do so. This would entail being over-weight in bond classes that have more default risk (corporate, high-yield, munis, and emerging market bonds) and being under-weight Treasury bonds. In equities, one would favor emerging market equities more heavily relative to developed market equities.
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