Edward Chancellor, Boston-based head of capital markets research and a member of the asset-allocation team at the $106 billion GMO, says the firm’s seven-year forecast has the S&P500 returning essentially zero returns on an annualised basis.
But he says US equities can deliver an annualised return of around 4%, based on a combination of small- and mid-caps on the one hand, and a selection of the highest quality blue-chips on the other.
GMO expects a better return from emerging-market equities, forecasting these will provide annualised performance of 5% over the next seven years. But the firm is bearish with regard to China.
“China is like California on steroids, before the global financial crisis,” says Chancellor. He expresses considerable reservations about the impact of its credit growth splurge since 2009, characterised by fixed asset investments into questionable infrastructure projects, which depend on real estate sales by local governments to pay back the banks.
China and other emerging markets are at risk partly because they have tied their monetary policies to the United States, where quantitative easing is worsening global macroeconomic imbalances.
“If you want risk, China is either good or bad,” Chancellor says. In his case, he’s a bear, arguing that any slowdown in credit growth in Hong Kong and China could have a catalyst effect on domestic GDP growth rates.
He’s not predicting a crash, but says investors should be concerned if China, the world’s main source of incremental demand, struggles to normalise its economy following the credit binge of 2009-2010. He is also worried that other big emerging markets are hitting a value trap and will struggle to transition to the next level of growth and per-capita wealth.
The biggest concern the world faces post-GFC, however, is the eurozone. “The problem of the euro is the most important because it’s so intractable,” Chancellor says. He describes the eurozone’s bind as worse than the Gordian knot central bankers faced in the 1930s when they went out of their way to preserve the gold standard.
But when central banks did abandon the gold standard, they found the results were actually beneficial. They had been restrained by psychology and belief. But today the eurozone’s existential questions are not psychological. There will be real, painful consequences to either fiscal integration or to kicking members such as Greece out of the currency union – or to doing nothing.
After the euro, Chancellor lists China as the next biggest problem for investors and the world economy, but he acknowledges that there are many opinions about its severity and how to tackle its structural issues, including its fixed currency arrangement, its vast accumulation of foreign reserves, and the ability for China to boost consumption as a percentage of GDP.
In this light, he says the US story has its problems but it looks comparatively better. It does suffer from structural problems, unsupportable debts and a low savings rate.
However, Chancellor notes, that debt is denominated in US dollars, and demand for US Treasuries remains strong because of the dollar’s reserve currency status – a view borne out in the wake of the downgrading of the US credit rating by Standard & Poor’s, which only encouraged more buying of Treasuries.
“The reserve status cuts the US some slack,” he says, adding the cheap dollar helps with exports and could boost inflation, and the economy is flexible, at least compared with other developed countries. The real-estate market remains in the doldrums but prices are starting to look cheap, and America’s demographics are better than many other countries’.
That said, while he believes active managers can deliver performance in US equities, GMO is negative on the S&P500 index because US corporate profit margins, in general, are unsustainable; Chancellor argues profits have been propped up by government deficit spending, and the recent turn to fiscal tightening will make the environment more difficult for companies.
His pet favourite market over the next seven years is Japan, which he says could deliver 5% annualised returns. He calls Japanese equities a better inflation hedge than gold. “Japanese banks are trading at 0.6x price to book, they are underleveraged, their lending rates are low, but their profits are improving. If Japan ever grows again, higher interest rate margins and more lending would do wonders.”