One of the perks of our job is we get invited to great conferences. Jessica was able to attend a special conference Vanguard held for independent financial advisors like ourselves. The keynote speaker was Burt Malkiel (author of “A Random Walk Down Wall Street” and someone who has gotten the big picture right consistently over 35 years)
What Malkiel had to offer:
Emerging markets generally will shine but specifically China, China, China. He has visited 6 times and is convinced that China will be the global engine for growth. China is currently the third largest economy in the world. It should overtake Japan in a few years and the US in 15 years.
The government in China is absolutely committed to developing the western part of the country and has a larger and more targeted stimulus plan than the United States. They have ambitious infrastructure investment plans and are starting to build a safety net so that Chinese consumers will start to consume instead of saving all their money (consumption is only 37% of GDP and savings rate is around 40%). China has the capacity to make enormous investments because its debt to GDP is only 25% today, vis-a’-vis Japan and the US where it is over 100%.
Malkiel’s take away is that China can continue to grow at 9% a year and will be able shift to more domestic sources of growth rather than a reliance on export of cheap goods abroad.
By contrast, the US has strong economic headwinds. He doesn’t think the US will go back into recession but he sees a very long drawn out slow growth type recovery. Bank of America and Citibank are insolvent, for all intents and purposes. Chinese banks by comparison are actually quite well capitalized. Given the significant issues that these banks had with bad loans to quasi-government institutions, this is saying something. It reflects a conscious effort to clean up the banks over the last decade so that as the market slowly opened up the banks would be able to compete with foreign financial institutions.
US household liabilities over the last 50 years have gone from 40% of assets in the 1960s to 150% today. Household debt as a percentage of GDP has gone from 20% of GDP to 100%. There will be a LONG adjustment period as the country deleverages. Banks are not lending as they try and rebuild capital while exercising extreme caution.
Dollar weakness may continue, while other countries like China will express appreciation. Malkiel thinks that the Yuan (the Chinese currency) is the most undervalued in the world.
US has 42% of the world’s equity capitalization currently. Our investors have an extreme home country bias and people should consider an international allocation up to 40% (more if including US companies with a significant international presence). In the short term, he has no idea what returns investors should expect. Over the long run, equity investors will be rewarded. At this point, equities still offer the potential for out performance over government bonds but no should expect double digit returns.
He stressed the importance of looking at valuations using “normalized” profit margins. Current profit margins are much more realistic than they were a couple of years ago. There is still the challenge of knowing whether you can trust that earnings numbers are accurate. One alternative is to look at dividends, which cannot be fudged. The market is now much cheaper than it was in 1999, but is nowhere close to depression era levels. International values are reasonable, but not dirt cheap, and offer some inflation protection for investors. Chinese valuations, adjusted for growth, are attractive.
Should you diversify into bonds? The answer is yes, because they are the only thing that is not correlated with other assets in a decline.
The Fed has expanded its holdings by $2 trillion which is concerning to a lot of people because of the challenges in unwinding all of these support programs and the potential for inflation. In the next couple of years, there is very little inflation risk but over the longer term inflation risk is significant.
And, oh yeah, China rocks.
And, oh yeah, Burt Malkiel is now the CIO of a company that is sponsoring China-based indices and investments. Just something to be aware of…
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