According to Rob Arnott of Research Associates, a prominent strategist, U.S. bonds and equities are too expensive and will likely deliver negative real returns in the decade ahead. This is hardly a unique assessment; based on the ratio of the total market cap of U.S. companies to the country's GDP, the stock market has never before been this overvalued. Arnott explains:
"U.S. stocks have a yield of 1.5%. Historically, they produce a growth rate that is about 1.0% to 1.5% above the rate of inflation. Well, that gets you to a 2.5% to 3.0% real return - a far cry from what most investors want to expect from stocks. Then there is the valuation component. We're currently at a price relative to 10-year smoothed earnings, a Shiller P/E ratio of 38. Historic norm is 18. Now we don't assume a mean reversion to 18. We know that maybe it's a new normal, maybe this is the new normal for valuations. Or maybe it does mean a revert, as it has in the past. Let's split the difference. Let's instead of going from 38 to 18, let's go from 38 to 28. Well, that's going to cost you about 5% to 6% per year compounded, bringing your real return slightly negative. OK, well, that's where we come out with an expectation that the real return will be negative, and that the nominal return will be modest."
On the other hand, emerging markets (EM) are much cheaper for both bonds and equities. Arnott suggest investors allocate increasing amounts of their portfolio to emerging markets as well as developed markets outside the U.S.
Following is a chart from Research Associates showing annualized expected real (after inflation) returns (Y-axis) and volatility (X-axis) over the next decade. Emerging market stocks are expected to deliver over 5.6% real returns while U.S. large cap stocks are projected to yield -0.9%.
Chinese Domestic A-Shares
One investment area which may be opportunistic and timely in the emerging markets area is Chinese domestic value stocks, given the recent drawdown in Chinese equities.
The Bill & Melinda Gates Foundation Trust certainly seems to think Chinese equities offer value. Last month, the Trust bought over a million shares of Morgan Stanley (MS, Financial) Closed-End Fund - China A shares (MS-A share fund) (CAF, Financial). The fund has delivered an annualized performance of 8.93% over the last 10 years. According to Morningstar, the fund is currently selling at a 10.9% discount to Net Asset Value and has distributed 11.26% to shareholders in the last year. The performance (with dividends) as shown below has been impressive.
The MS-A share fund is a $500 million closed-end fund or CEF. CEFs are actively managed mutual funds that trade on an exchange like a stock. CEFs can play a key role in a diversified portfolio, providing the potential for income and capital appreciation. CEFs are typically listed on a major exchange such as the New York Stock Exchange, which provides the benefit of intra-day liquidity for investors. The “closed” structure allows portfolio managers to access a broader opportunity set including less-liquid investments that offer higher income and return potential. CEFs can borrow money to increase exposure to investments with the goal of enhancing income and capital appreciation potential. This leverage can also increase risk in down markets.
A-Shares are securities of Chinese incorporated companies that trade on either the Shanghai or Shenzhen stock exchanges. They are traded in Renminbi (Chinese Yuan). They can only be traded by residents of the People’s Republic of China or under the Qualified Foreign Institutional Investor (QFII), the Renminbi Qualified Foreign Institutional Investor (RQFII) rules, or via the Stock Connect programs. A-Shares are key to access China's growing domestic economy. The MS-A share fund charges an expense ratio of 1.75% a year to allow foreign investors to hold these shares indirectly. The fund is currently trading at a discount of 9.69% to its Net Asset Value (NAV). Currently, the fund has a 11.13% dividend distribution rate.
Following is a list of the assets the fund invests in:
The fund, which has been around from 2006, has performed well in the long term but has lagged its benchmark in the shorter time frames. This is because of the out-performance of the tech names in China which are predominantly listed off-shore and in Hong Kong (H-shares).
I think this move by the Gates foundation into China's domestic economy via A-Shares is interesting and opportunistic. Given the difficulty of non-Chinese retail investors to access the Chinese stock market, investing via CAF is a great vehicle to do so.
