Future Returns: Ignoring Market Noise for the Long-Term
When it comes to volatility in the stock market, long-term investors are advised to ignore the drama.
When it comes to volatility in the stock market, long-term investors are advised to ignore the drama.
Simply, short-term market reactions—justified or not—are just that, short-term. As Deepak Puri, Deutsche Wealth Management’s chief investment officer for the Americas notes, many of the issues causing the market’s recent swings—from the Federal Reserve’s decision to scale back economic stimulus, to concerns over whether Congress will lift the debt ceiling, to worries over China’s regulatory crackdown on a range of companies—are finite, and unlikely to have a long-term effect on the outlook for stocks.
“A lot of these issues we are grappling with have a finite shelf life, and if you look past that, the path of least resistance for the market is still on the upside,” Puri says. A key reason? Negative real interest rates—that is, rates adjusted for inflation— “create a favourable backdrop to own equities,” he says.
While the yield on the U.S. 10-year Treasury note has risen 17 basis points in recent days to 1.482% as of Monday’s close, rates are still relatively low, and the stock market—although expensive—still presents better risk-return characteristics than other sectors, such as Treasuries or investment-grade corporate bonds, Puri says.
“To find a better alternative for equity markets is pretty difficult at this point,” he says.
Penta recently spoke with Puri about where long-term opportunities lie, and where investors should look for value within stocks.
‘Structural Forces’ Continue to Support Stocks
The reason equity markets continue to be worth investing in despite already considerable growth is what Puri refers to as the positive, long-term structural forces “which have more sustenance” than finite concerns, such as the debt travails of China Evergrande Group, a large property developer.
Concerns over the implications of Evergrande’s inability to handle its debt burden contributed to a more than 600-point fall in the Dow Jones Industrial Average on Monday, Sept. 20—a drop that was erased by Friday, although on Tuesday, stocks were nosediving again as the 10-year yield continued to rise.
The substantive, structural forces Puri was referring to include the favourable macroeconomic environment created by low and even negative interest rates. Low rates mean investors should be much more comfortable owning stocks, he says.
As Puri explains, if investors worried about pricey stocks were to put all their money in cash and Treasury bills paying an interest rate of about 0.05%, it would take 1,000 years or more to double their money. By contrast, it would take seven-and-a-half years for investors to double their money in stocks, given equity markets historically have risen 10% a year. Even a more conservative estimate of a 5% annual rise in stock market returns would lead investors to double their money in 14-and-a-half years.
“Compare 14-and-a-half years versus a millenia if you are sitting in cash,” Puri says. “The alternatives to really challenge high-quality blue chip equities are limited at this point.”
Another structural boost comes from governments in both developed and emerging markets, which have stepped in with spending to counter the economic blows of the pandemic. Puri believes these actions point to a longer-term trend of increased spending by governments as a percentage of GDP. In the U.S., the spending began with stimulus to blunt the effects of the pandemic, and it continues with expected spending on infrastructure—from roads and bridges, to green technologies and “human infrastructure” such as spending on child care and education.
“That’s a structural shift that’s taking place that creates a favourable outlook for companies sensitive to that spending,” he says.
And, Puri notes, corporate earnings continue to grow at double-digit levels. Even though earnings growth is expected to moderate, and the stock market could swing lower should earnings growth dip, the overall outlook for earnings, and the ability of companies to pass on higher costs, remains strong.
Of course, these forces don’t mean equity markets will continue to go up in the short-term, as Tuesday’s market action shows. Bond yields are rising, the coronavirus pandemic remains a factor and could still derail growth, and the inability of Congress to address the debt ceiling could be crippling as well.
“Any sort of disappointment [about] liquidity, better economic growth, or a Covid resurgence could derail that linear trajectory we’ve been seeing in the stock market,” Puri says.
Where to Find Value
Puri says he often advises investors to look at what they own. Many don’t realize how much exposure they have to big technology names including Amazon or Alphabet, which dominate sectors such as consumer discretionary companies or communication services, for example.
Although the economy’s reopening has been delayed by the considerable setbacks caused by the Delta variant of Covid-19, Deutsche Bank expects the reopening will accelerate as vaccination rates rise, and that cyclical businesses, including banks and consumer discretionary companies, will benefit.
If investors are worried about inflation, Puri says they could consider investing in Treasury Inflation Protection Securities—bonds that adjust the principal payment according to inflation rates—or in bank loans, which, because of their short-term nature (generally one-year or less) have little exposure to interest-rate risk and can deliver slightly higher returns than Treasuries.
A Different Approach to Bonds
Typically, bonds serve two purposes in a diversified investment portfolio: they provide a hedge when stock markets slide and a return from the bond’s appreciation and coupon. In the past, the same security provided both, but “no longer is that possible,” Puri says.
Investors can own bonds for hedging—without expecting much in the way of returns—or they can own bonds that generate a yield (such as emerging-market bonds or high-yield corporate bonds), although the latter will behave more like risky assets, including stocks, than as a hedge.
“For most individual investors, you should have both,” Puri says. “ A fixed-income component purely for hedging—for when things don’t go well, volatility spikes, and equity markets are going down—and another part that gives you income.”
Stay Invested in China
China’s regulatory reining in of Alibaba Group Holding Ltd., the ride-hailing company Didi Global, tutoring services such as New Oriental Education & Technology Group, and debt-laden property developers such as Evergrande, raises concerns about investing in China, but Puri doesn’t advocate investors shun Chinese stocks.
For the near term, Deutsche Bank’s view is that for China specifically, and Asia in general, “it’s too late to sell, but maybe too early to buy,” considering the potential for further volatility.
Longer term, although Chinese growth prospects are down slightly, it’s important for investors with return on their investments as a primary motive to “keep China in your portfolio,” he says.
Many large Chinese companies “are big and profitable in their own regard, and are market leaders,” Puri says. “For a global investor, you need to keep your eyes open. If you are looking for return on your investment as your primary motive [for investing], keeping political and ideological views aside, then keep China in your portfolio.”
Also, the regulatory crackdown has a lot to do with China wanting more visibility into how companies do business, its desire to curtail monopolistic tendencies, and to promote Chinese family values. While the next few months could still be volatile, Deutsche Bank expects the upcoming reelection of China President Xi Jinping next year will create a more favourable macroeconomic backdrop.
Still, he notes, the country, despite its growth, is considered an emerging market. “This is a stark reminder that there are risks that are non-security specific related in these markets,” Puri says.
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Says U.S. and China, which will continue to see a surge in borrowing if current policies remain in place.
The U.S. and Chinese governments should take action to lower future borrowing, as a surge in their debts threatens to have “profound” effects on the global economy and the interest rates paid by other countries, the International Monetary Fund said Wednesday.
In its twice-yearly report on government borrowing, the Fund said many rich countries have adopted measures that will lead to a reduction in their debts relative to the size of their economies, although not to the levels seen before the Covid-19 pandemic.
However, that is not true of the U.S. and China, which will continue to see a surge in borrowing if current policies remain in place. The Fund projected that U.S. government debt relative to economic output will rise by 70% by 2053, while Chinese debt will more than double by the same year.
The Fund said both countries will lead a rise in global government debt to 98.8% of economic output in 2029 from 93.2% in 2023. The U.K. and Italy are among the other big contributors to that increase.
“The increase will be led by some large economies, for example, China, Italy, the United Kingdom, and the United States, which critically need to take policy action to address fundamental imbalances between spending and revenues,” the IMF said.
The IMF expects U.S. government debt to be 133.9% of annual gross domestic product in 2029, up from 122.1% in 2023. And it expects China’s debt to rise to 110.1% of GDP by the same year from 83.6%.
The Fund said there had been “large fiscal slippages” in the U.S. during 2023, with government spending exceeding revenues by 8.8% of GDP, up from 4.1% in the previous year. It expects the budget deficit to exceed 6% over the medium term.
That level of borrowing is slowing progress toward reducing inflation, the Fund said, and may also increase the interest rates paid by other governments.
“Loose US fiscal policy could make the last mile of disinflation harder to achieve while exacerbating the debt burden,” the Fund said. “Further, global interest rate spillovers could contribute to tighter financial conditions, increasing risks elsewhere.”
A series of weak auctions for U.S. Treasurys are stoking investors’ concerns that markets will struggle to absorb an incoming rush of government debt. The government is poised to sell another $386 billion or so of bonds in May—an onslaught that Wall Street expects to continue no matter who wins November’s presidential election.
While analysts don’t expect those sales to fail, a sharp rise in U.S. bond yields would likely have consequences for borrowers around the world. The IMF estimated that a rise of one percentage point in U.S. yields leads to a matching rise for developing economies and an increase of 90 basis points in other rich countries.
“Long-term government bond yields in the United States remain elevated and sensitive to inflation developments and monetary policy decisions,” the Fund said. “This could lead to volatile financing conditions in other economies.”
China’s budget deficit fell to 7.1% of GDP in 2023 from 7.5% the previous year, but the IMF projects a steady pickup from this year to 7.9% in 2029. It warned that a slowdown in the world’s second largest economy “exacerbated by unintended fiscal tightening” would likely weaken growth elsewhere, and reduce aid flows that have become a significant source of funding for governments in Africa and Latin America.
An unusually large number of elections is likely to push government borrowing higher this year, the Fund said. It estimates that 88 economies or economic areas are set for significant votes, and that budget deficits tend to be 0.3% of GDP higher in election years than in other years.
“What makes this year different is not only the confluence of elections, but the fact that they will happen amid higher demand for public spending,” the Fund said. “The bias toward higher spending is shared across the political spectrum, indicating substantial challenges in gathering support for consolidation in the years ahead, and particularly in a key election year like 2024.”
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