Podcast Summary
US small caps present investment opportunities: Undervalued US small caps offer potential for attractive returns, but investors should carefully consider risks and focus on financially viable companies
US small caps, which are typically more fragile and faster-growing than large cap companies, are currently undervalued and could present attractive investment opportunities. With many small caps experiencing lower valuations and stricter inclusion criteria in certain indices, investors may be able to filter out the riskier stocks and focus on those with strong financial viability. The current forward price-to-earnings ratio for US small caps is nearly at historic lows, indicating a significant discount compared to forecast profits. However, it's essential to consider the potential risks, such as economic downturns, and the uncertainty surrounding those forecast profits.
Small cap value stocks in US could offer attractive opportunities: Historically undervalued small cap value stocks in US may outperform, but investors should research before investing. Chinese stocks face challenges due to anti-market policies, lack of transparency, and economic uncertainty.
The US small cap market, particularly small cap value stocks, could offer attractive investment opportunities despite the ongoing economic uncertainty and potential for a recession. The small cap value segment is historically known for its outperformance, and the current forward PEs suggest it is significantly undervalued. However, investors should conduct their own research and make informed decisions. Regarding Chinese stocks, the market has faced significant challenges this year due to anti-market policies and a lack of transparency. The recent reappointment of President Xi Jinping and the strict COVID-19 policies have raised concerns about the economic impact, as indicated by the price of copper. The delayed release of growth figures during the Communist Party conference further highlights the reliability of data in the Chinese equity market. Investors should exercise caution when considering investments in Chinese stocks.
China's Economic Challenges: Cheap but Risky: Despite a cheap valuation, China's economic situation is uncertain due to government crackdowns, property bubble, trade war, and potential ideological shifts.
China's economic situation looks exceptionally cheap right now, but the risks and challenges facing the country are significant. The narrative of China as a cheap, modernizing country with huge growth potential has largely unwound, and indices tracking Chinese equity have not grown since 2010. The Chinese government's crackdown on technology companies, the property bubble, and Xi Jinping's consolidation of power have all contributed to a less business-friendly environment. Additionally, the trade war between China and the US has escalated, with strong restrictions on chip exports and Americans working on Chinese microchip designs. However, there are potential bull cases for China. The country still needs to raise capital and may continue to open its markets to foreign investment. Xi Jinping's focus on common prosperity could lead to policies that promote growth, and the chip ban could force China to innovate and develop its own manufacturing processes. However, the risks of a more ideological China that disregards international opinion and takes actions that could negatively impact global markets cannot be ignored. Ultimately, investors must carefully consider whether the potential rewards outweigh the risks when considering investments in China.
Chinese equity: Attractive despite political concerns and economic risks: Investors weigh China's infrastructure investments and long-term policies against political uncertainties and economic risks for attractive equity opportunities, while TIPS underperform due to rising real yields, requiring careful analysis and risk management
Despite concerns about political leadership in China and potential economic risks, the country's infrastructure investments and long-term policies make Chinese equity an attractive investment option for some. However, the risks cannot be ignored, and the market's recent sell-off has made the asset class look particularly cheap. Meanwhile, US inflation-linked government bonds, or TIPS, have underperformed this year due to rising real yields, despite inflation being high. Investors need to be aware of the duration risk associated with TIPS and consider the potential impact of future yield movements on their returns. Overall, both Chinese equity and TIPS present unique opportunities and risks for investors, and careful analysis and risk management are crucial.
Will real growth fall or remain around 2-3% in the US?: Investors should consider adding inflation hedges to their portfolios as a precautionary measure, especially for those approaching retirement, as the speaker believes inflation is more likely to surprise on the upside.
Real yields and real growth are roughly at par in the US, leading to the question of whether real growth will fall in the next decade or remain around 2-3%. The speaker suggests that real yields have already risen significantly and may not continue to do so at the same pace. He also discusses the potential appeal of nominal bonds over inflation-linked bonds, depending on whether one believes inflation will come down sharply or stay elevated for an extended period. The speaker expresses his view that inflation is more likely to surprise on the upside, but acknowledges that there is a risk of it coming down. He also mentions that the 5-year breakeven inflation rate, which is currently at 2.7%, might be low considering the current high inflation rates. Ultimately, the speaker suggests that investors should consider adding inflation hedges to their portfolios as a precautionary measure, especially for those approaching retirement.
Adding Inflation-Linked Bonds to Retirement Portfolio: Consider adding inflation-linked bonds to retirement portfolio to keep pace with inflation, especially as retirement approaches. Ignore short-term price fluctuations in commodities, as markets can be volatile.
As you approach retirement, it's wise to consider adding inflation-linked bonds to your portfolio for their ability to keep pace with inflation. Vanguard's target retirement funds, for instance, begin to incorporate these bonds closer to retirement. While commodities, particularly energy, have seen a trend of increasing prices due to undersupply and infrastructure issues, recent developments such as OPEC supply cuts and European gas oversupply have caused prices to dip. However, experts caution against getting too distracted by short-term price fluctuations, as commodity markets can be volatile and prices can turn around quickly. In the case of energy, prices are still high for the first and second quarters of next year, and government policies to protect vulnerable households could also impact prices.
Gaining Exposure to Commodities through ETFs: Be Cautious: Invest in commodities like natural gas through ETFs with caution, consider Chinese demand, be aware of underinvestment in infrastructure, and brace for high volatility.
Investors can gain exposure to commodities like natural gas through Exchange-Traded Funds (ETFs), but it's essential to be cautious about the specific contract and underlying market they provide exposure to. Additionally, Chinese demand plays a significant role in commodity prices, particularly for metals and energy. The underinvestment in commodity infrastructure over the past decade due to low profit margins and ESG concerns may lead to supply shortages in the future. However, the high volatility and potential for sudden price swings make commodities a risky investment. The speakers suggest being selective with commodities, such as natural gas and copper, and avoiding highly leveraged or frequently traded commodity funds. Ethereum or ether, the native cryptocurrency of the Ethereum blockchain, is another investment option, but the speaker expresses skepticism towards it due to personal preferences.
Ethereum's Potential Recovery and Comparison with Annuities: Belief in Ethereum's recovery and interest rate environment impact its investment appeal. Ethereum offers utility as a digital oil for smart contracts and apps, while annuities provide a stable income stream for retirees.
Ethereum, down 72% from its all-time high, could be an attractive investment for those who believe in its potential recovery. Its wide use as a computational substrate for various apps and the recent energy efficiency improvement from proof of stake to proof of work are positives. However, its lack of cash flow generation ability and lower yield compared to traditional bonds are negatives. The merge and the reduction in energy consumption have also potentially lowered regulatory risk, making Ethereum a more appealing option compared to Bitcoin in terms of environmental concerns. Despite the risks, Ethereum's utility as a digital oil that powers various smart contracts and apps sets it apart from Bitcoin, which is often referred to as digital gold due to its lack of utility. Ultimately, the success of Ethereum as an investment depends on the belief in its recovery and the interest rate environment. Annuities, another asset class, provide a guaranteed income stream for retirees in exchange for a lump sum payment, offering stability and security in contrast to the volatility of cryptocurrencies.
Annuities vs Self-Management: A Personal Choice: Annuities, offering guaranteed income for life, have regained popularity due to rising interest rates, but some prefer managing retirement funds themselves. Zombie companies, unable to pay debts, survive by selling assets to delay default.
Individuals have the choice between investing their retirement funds themselves and drawing down income throughout retirement, or purchasing an annuity from an insurance company to receive a guaranteed income stream for life. Annuities became less popular after pension reforms in 2015 due to low interest rates, but with the surge in interest rates, annuity rates have also increased significantly. If you believe in efficient markets, the decision to buy an annuity or not should not make a difference as market prices quickly reflect information. However, the speaker personally prefers managing his own retirement funds and passing them on to his family upon death. Another topic touched upon was the concept of "zombie companies," which are companies that cannot service their debt but still exist due to their ability to sell assets to stave off default for some time. These companies are essentially living dead in the business world.
The Surge of Zombie Companies in the Economy: Zombie companies, unable to cover interest payments, are vulnerable to liquidation as interest rates rise and economic conditions soften. Their funding costs have surged due to widening credit spreads. Consequences include higher unemployment, lower demand, and potentially lower inflation. Junk bonds and equities are heavily exposed.
The number of "zombie companies" in the economy, which are firms that cannot generate enough revenue to cover their interest payments but continue to exist due to low interest rates, has surged since the financial crisis. With rising interest rates and economic soft patches, these companies are increasingly vulnerable to liquidation. The all-in cost of funding for these companies has surged due to widening credit spreads. If a company's debt servicing costs exceed its revenue, it may become a zombie. Goldman Sachs suggests that the number of true zombies may be overestimated, as some companies may still be able to raise equity capital. However, with fewer credulous investors, this may not be an option for many companies. The consequences of a zombie apocalypse could include higher unemployment, lower demand, and potentially lower inflation. Certain asset types, such as junk bonds and equities, are heavily exposed to these companies. Ultimately, the disappearance of these zombie companies could lead to improved productivity and economic growth.
Creative Destruction: Forest Fire of Growth: The economic process of creative destruction results in job losses and financial hardship, but also brings new opportunities for growth
The economic process of creative destruction, where old and poorly allocated capital is replaced by new and vibrant companies, can lead to a surge of growth, but it comes at a cost. This process can result in job losses and financial hardship for individuals. It's important to remember that while this forest fire-like cycle of growth and destruction can bring about new opportunities, it's not a consolation for those directly affected. It's crucial to support and help those impacted during this transition. As always, this podcast is for informational and entertainment purposes only, and we encourage listeners to seek independent financial advice before making any investment decisions.
