Richard Bernstein: US Assets will Outperform over the Next Decade
Richard Bernstein is the chief executive officer of Richard Bernstein Advisors LLC, an independent investment adviser focusing on longer-term investment strategies that combine top-down, macroeconomic analysis and quantitatively-driven portfolio construction. The firm sub-advises the Eaton Vance Richard Bernstein Equity Strategy Fund, and the Eaton Vance Richard Bernstein All Asset Strategy Fund. Prior to founding the firm in 2009, Mr. Bernstein was the chief investment strategist at Merrill Lynch & Co. Prior to joining Merrill Lynch in 1988, he held positions at E.F. Hutton and Chase Econometrics/IDC. A much-noted expert on equity, style and asset allocation, Mr. Bernstein was voted to Institutional Investor magazine's annual "All-America Research Team" 18 times, including 10 as the top-ranked analyst in his category. He was recently inducted into the AART Hall of Fame – a recognition accorded to only 45 of the approximately 15,000 eligible analysts.
I spoke with Mr. Bernstein on April 30.
What is your general outlook for this year, starting with the US equity market?
We don’t make formal forecasts, such as whether the Dow will hit a certain number. But people should be looking in the US for above-average returns.
The US stock market is not expensive. I know that one can make a case that P/E ratios seem high, but you have to adjust them for interest rates, and if you do that they look actually quite normal – better than normal – regardless of the P/E you use. You can use the regular P/E or the Shiller P/E. The market looks at worst reasonably valued, at best downright cheap.
We are still getting huge outflows from equity mutual funds. When has a bull market ended with huge outflows from equity mutual funds? That has probably never occurred.
The corporate sector in the US is the strongest corporate sector in the world by far; nothing else is even close. Where people should be worried is not in the United States. They should be worried around the rest of the world. Most investors still think our problems are just US problems, and that the rest of the world is fine. People are starting to realize Europe has some problems, but what people still don’t have an inkling of is that the biggest problems are yet to come, and they are in the emerging markets.
We are still in the early stages of decade-long outperformance for US assets. The line I always use is the S&P 500 has now outperformed BRIC equities for more than four years, and nobody knows about it. Anybody who knows about it says it can’t possibly last. Yet it just keeps going on, and on, and on.
This is what bull markets are made of – improving fundamentals that people just don’t believe. That’s what we’ve got in the United States.
Corporate profits are fairly high now relative to history. Is it going to stay that way? If it doesn’t, how will that effect valuations?
One of the reasons why the stock market has done as well as it has over the past three-plus years has been that corporate profits are now the largest percent of GDP ever. The corporate sector has disproportionately benefited from this recovery. We all know that the household sector has not advanced tremendously, although it has improved. But the corporate sector has done great.
It is inevitable that the household sector will regain some of that national income. You are seeing it right now in the extremes of both parties: the Tea Party and Occupy Wall Street. The fact that the corporate sector is such a big part of this gain is unsustainable, as are the disparities of wealth that a lot of people talk about. When people question me about that, I say, “Just ask Marie Antoinette.” There are a lot more voters among the 99% than the 1%. Things are going to change and we should be prepared for that.
It means corporate profit growth will slow. There is no doubt about that.
What does it mean for valuations? It is going to depend on what happens in the rest of the world. I am a firm believer that the valuation of US assets will become dearer. In other words, multiples will expand, and interest rates will go lower as people begin to realize the risk outside the US is much greater than they anticipated.
People are underestimating the risk outside the US and overestimating the risk inside it. Over the next several years, there is going to be a reevaluation of those risks, and we should get higher multiples in the US.
I will come back to the emerging markets, but one of the things that people fear is the expiration of the Bush tax cuts and the fiscal drag that will supposedly come at the end of this year. What are your thoughts?
That is the biggest risk; the fiscal cliff is a big deal. You’re going to have the sequestration of spending and the Bush tax cuts will expire. We are going to cut spending and raise taxes all in one day.
I don’t care what side of the aisle you come down on. There is no way that is good for the economy.
The issue with the dividend taxes is one of the most interesting things, because for the highest-income tax earners, the dividend tax rate goes from 15% to about 43%. There are also changes to inheritance taxes and capital gains taxes. Everything is going up, and the likelihood of that happening is probably pretty good. In terms of dividend stocks – which are very, very popular these days – you could have some of what I like to call “dislocations.” All dividends are not dividends. Investors generally tend to talk about dividends as any form of equity income. That is not true. MLPs don’t pay dividends. MLP closed-end funds pay dividends. MLP ETFs pay dividends, but a MLP does not. So maybe a K-1 doesn’t look so bad anymore. I’m not even sure REITS pay dividends, technically.
Some dividend-paying stocks may therefore get better treatment than others, and investors may adjust accordingly. I personally think that the dividend tax increase is not going to happen. They are going to come to some agreement about some of these issues, but the fiscal cliff is the biggest risk sitting out there. The politics are such that nobody wants to get anything done. They don’t have to pass a single bill, and the fiscal cliff occurs.
Let’s turn to emerging markets. Do you expect a hard landing in China?
When you have a supposed growth investment, whether it is a country, a stock, or anything else, and you use the word “landing,” it makes no difference whether it is hard or soft. You have to be very, very cautious, because people get caught up in the adjective. The suggestion is that if it is only a soft landing, it won’t matter. But it is important to remember markets don’t act on the absolutes of good and bad. Markets act on better or worse. If you are talking about a landing, it implies a worse situation than you presently have. It is very hard to find a stock market that does well when things are getting worse. That’s what’s been going on in the Chinese market.
On top of that, China’s ongoing credit bubble makes the US credit bubble look downright amateurish.
If you didn’t like Fannie and Freddie’s role in the US economy – and I’m not particularly a fan of them – you can’t like China. At least Fannie and Freddie were constrained to the housing market. The Chinese government is in every single industry, lending and facilitating credit.
People are kidding themselves when they think China’s economy was just a normal event going on for the last three, four or five years.
Are you are referring specifically to the 8% to 10% growth in the Chinese economy?
Yes. Over that period, growth was predicated on a huge, huge, credit bubble.
Here is a good way to think about it: People always talk about the great trains, infrastructure, roads and airports in China. Nobody ever asks, “How did they finance that?” A lot of it was financed by local governments that now can’t pay them back and the government is assuming all those loans.
They have been printing Renminbi like crazy. The People’s Bank of China’s balance sheet is now 50% bigger than the Fed’s, according to Bianco research. So why isn’t anybody worried about the dollar? I mean this is kind of nutty. The ECB’s balance sheet is now bigger than the Fed’s too, by the way. People are putting their head in the sand, hoping that China isn’t in a credit bubble. But it is the biggest one of my professional career.
Do you have a forecast as to the timing of how things will unfold with China?
If you look at the early-warning radar, it is already starting. Default rates are going up. Delinquency rates are going up. The Chinese government is assuming loans. It is already starting to deflate.
Beyond China, do you see a similar situation in the other emerging markets?
It depends. It may be unfair to put all four of the BRICs together, other than in a marketing concept. They are all very credit-induced economies. They can’t try to fight inflation, because their currencies would appreciate. They can’t really exist with inflation, but inflation expectations are rising. For example, the Brazilian real has been falling as inflation expectations go up in Brazil.
You’d think the Brazilian central bank would be like the Bundesbank, given its history of hyperinflation. You’d think they’d be one of the tightest central banks in the world. But nothing could be farther from the truth. They are now accepting inflation, and their currency is falling accordingly, and inflation expectations are going up.
I don’t see how that’s good for a dollar-based investor.
You mentioned earlier you expect interest rates to go lower.
Everybody asks me what is the probability that the US economy turns out to be Japan? My answer is that is the wrong question. You should be asking what is the probability the entire world turns out to be Japan?
When people ask, “Is the US becoming Japan?” they have their blinders on. They think the credit bubble is only a US credit bubble, but we know there’s been a credit bubble in Europe. We know there has been one in the emerging markets. It’s a global phenomenon. So why would only the US become Japan? Why wouldn’t the whole world become Japan?
There is a fair amount of risk in the entire world. People’s expectations for global growth are much too optimistic. If slower growth happens, investors are going to be running to safer assets.
I don’t care what the politicians tell me. I care what the markets tell me. The highest-quality assets in the world are Treasury securities.
The US is going to benefit from the rest of the world’s problems. We are going to get lower long-term interest rates, but not because our own economy is shrinking. We’re going to get lower interest rates because the global economy is shrinking. That is going to be very good for the US economy going forward.
Do you expect an overall deflationary picture in the US?
I don’t think we are going to have deflation here. We’ll have very moderate inflation.
The extremes – massive deflation or massive inflation – are not likely in the US. That may occur in other places. If Greece goes back to the drachma, you’ll see some pretty hefty inflation. In some of the emerging markets, you are already seeing some pretty decent inflation rates. But for the US it is going to be very moderate or maybe slight deflation.
What are your thoughts on the housing market?
We are reasonably bullish that housing is improving, but that doesn't mean home prices are going up. People have to remember that inflation is a lagging variable, although when we are talking about homes, we don't call it inflation; we call it appreciation. But you have to see housing activity pickup before home prices will pick up.
When I was at Merrill, my argument was that if you bought your house in 2006 at the height of the bubble, you'd be lucky to break even by 2016. I still think that is the case. That's actually very optimistic. But housing activity will pick up. Housing activity and housing prices are separate things. Right now, it is more important to watch housing activity than housing prices.
Isn't there still a fairly large inventory of homes that needs to get back to historical levels before we can have any hope of price increases?
People forget their economics. The only way that prices ever go up is when demand is greater than supply. If we've got a huge inventory of homes, it is going to be a long time before demand is greater than supply, so do you shouldn't expect prices to go up, especially in an environment where credit availability is constrained.
You’ve written recently that investors should change their thinking about diversification. How so?
Investors don’t understand why alternatives became popular. Through the 1980s and the 1990s, you could not diversify a portfolio using traditional stock, bond and cash allocations, because stocks and bonds were positively correlated. They went up together; they went down together. There was no diversification, so one had to find an alternative to traditional stock-bond-cash allocations.
About six years ago, Treasury securities started to have a negative correlation to stocks. When I was at Merrill Lynch, we used to write extensively about how Treasury bonds were a good balance for the stock market. Now it has gotten even more extreme, to where all the supposedly uncorrelated assets are all correlated with stocks.
If you look at hedge funds and private equity, they are all positively correlated to equities. You can’t diversify a portfolio with alternatives anymore. They are not an alternative; they are mainstream. The fact that everybody is willing to invest in them says they’re mainstream.
Diversifying asset classes are out-of-favor because they don’t fit what people think you should be investing in. That’s why they diversify. Nothing could fit into that description better right now than Treasury securities. Despite the fact that they muted portfolio volatility in 2008 and again last summer, people still don’t want to hold Treasury bonds. It’s incredible. It’s one of the reasons we think Treasury rates are going lower.
You are predicting a strong market for US equities and a strong market for Treasury securities, so they are both going to go up.
Correct. Too many people think in terms of stocks versus bonds. Our story is, “No, don't think of stocks versus bonds; think of US versus non-US.”
People just can't believe that US assets could be the gem of the world financial markets.