Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
I'm here today with Matt Coffina, the editor of Morningstar StockInvestor newsletter. We're going to look at some risks that investors are seeing in the market today and how they should think about them.
Matt, thanks for joining me.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: One of the risks investors seem to be most worried about today is the Federal Reserve and when rates are going to rise, or if they are going to rise faster or sooner than the market is expecting.
What's your take on this? Are you worried about how rising rates could impact your portfolio?
Coffina: Interest rates are definitely one of the biggest risks that we face and one of the most unavoidable. For us, our interest rate risk is particularly acute in the Tortoise Portfolio, where we tend to own larger, more steady, slower-growing, less economically sensitive businesses, often with relatively higher dividend yields. So, companies in consumer staples, health care to a certain extent, midstream energy, utilities, real estate investment trusts. These kinds of companies tend to be much more sensitive to interest rates.
On the other hand, we also own a couple of companies, Charles Schwab (SCHW) and Wells Fargo (WFC) come to mind in particular, that would benefit from higher short-term interest rates, and I think it's nice to have a couple of names like that in your portfolio to balance out the general interest rate risk, which is usually that higher interest rates are bad for equities--or at least that's what's perceived.
The other side of the story, though, is that if the Federal Reserve is raising interest rates, it's a good bet that the economy is showing some strength, that maybe unemployment is falling faster than was expected, that GDP is growing better than was expected, and that's a good thing for stocks in the long run, in my view. A stronger economy means higher cash flows, and that usually is more than enough to offset the potential for a higher discount rate that comes with higher interest rates. So overall, I don't think higher interest rates are all bad, especially if they're associated with a stronger economy.
Then the other thing I always like to ask myself is, is this going to matter in 10 years? I think the reality is that if the economy continues to grow at a decent pace, more consistent with the long-run historical average, you expect interest rates to eventually normalize at, call it 3% to 5%, a more normal kind of level--maybe 2% inflation plus the 2% real return. And I think that's healthy. Whether we get there next year or two years from now or five years from now, I think that's where we're headed in the long run.
I'd be much more concerned if we were in a situation where interest rates stayed at 2% or 3% indefinitely, because that probably means the economy is stagnating, maybe we're facing an ongoing risk of deflation, we're more in a Japan kind of scenario, and that certainly wouldn't be good for common stocks.
Glaser: How do you think about geopolitical risks today? There are lots of bad headlines out of the Middle East, fears over things like Ebola. Do you take any of these into account when you're considering investments? Is this something that investors should really be thinking about when making portfolio decisions?
Coffina: There is no shortage of scary headlines, but I think they're really more concerning from a humanitarian standpoint than they are from an investor's standpoint.
Most companies are not generating a whole lot of cash flow in the Middle East or West Africa. The Middle East has been in turmoil forever. Ebola, to the extent that it became a global pandemic, you'd have to be concerned about the economic implications of that, but it doesn't seem like we're going in that direction. These are really more isolated regional incidents.
So, again, I think they are worth monitoring from a humanitarian standpoint, and I'm concerned from that perspective. But from an investor's perspective, it's really hard to see those kinds of events having a significant impact on the long-run earnings power or the valuations of the kinds companies that we tend to own.
Glaser: How about regulatory risk? This has been on a lot of people's minds after the elections and as the Supreme Court takes another Obamacare challenge. How do you think about regulatory risk in terms of your companies, in terms of direct impacts and indirect ones?
Coffina: There is no escaping regulation. Every company is regulated to one extent or another. It tends to be more of a company-by-company issue. For example, the Republicans now taking control of the Senate, deepening their hold over the House--that could have positive implications for a company like TransCanada (TRP) that's been trying to get its Keystone XL Pipeline through the regulatory process, trying to get approval in the U.S. to cross the Canada-U.S. border. TransCanada is a company we happen to own in our Tortoise portfolio.
Certainly with our regulated utilities, it's more of a case-by-case basis. We own ITC Holdings (ITC), which is regulated at the federal level. But there it's very hard to see the election or anything else having an impact specifically, but we do want to watch the regulatory process at FERC [the Federal Energy Regulatory Commission]. For example, ITC right now is awaiting a decision on its allowed returns on equity in the MISO region, which is its key region for electricity transmission infrastructure. But I don't see the election having any impact on that in particular. But we are monitoring the regulatory process.
More generally, I think Washington remains gridlocked. Even with Republicans taking control of both Houses of Congress, the Senate is still very closely divided. It's very hard to get any kind of legislation passed without 60 votes. You'd recall that Democrats had a brief window of 60 votes early in the Obama administration.
That's when they were able to get some major pieces of legislation passed, like the Affordable Care Act; we're now going to be probably working through challenges and tweaks to for the next decade or more. But without that 60-vote majority, it's very hard to get any significant legislation passed, and especially with the Democrats retaining control of the presidency, it's very hard to see any really major legislative or regulatory changes in the near future.
I think that's actually probably a good thing for investors. It means the status quo won't be disrupted too much. You always have to be concerned about, for example, will tax reform have a major implication on the tax structure for master limited partnerships?
It becomes incrementally less likely, probably, with Republicans in control of Congress. But even so, I think there was enough gridlock that you're not going to see major changes to the status quo there. So, from an investor's perspective, it's pretty much steady as she goes--the same situation we've had over the last four years. Lots of gridlock in Washington means not a lot gets done, and that at least removes the risk of a major disruption from regulatory change.
Glaser: How about currency risk? There have been some big swings with the U.S. dollar becoming stronger versus the euro and the yen, in particular. Are you worried about how currencies could impact your portfolio holdings?
Coffina: Currency risk is certainly an issue that's worth worrying about. This has mostly affected our consumer staples holdings, so companies like Coca-Cola (KO) and Philip Morris International (PM), which are very global businesses, generating a lot of earnings outside of the U.S., and those earnings become less valuable when the dollar becomes stronger--those foreign earnings become less valuable in dollar terms. We've already seen a huge strengthening of the dollar, and that's been a negative for our investments, quite frankly.
But going forward, currency is not something that I try to predict. Similar to trying to predict economic growth over the next year or two, trying to predict where currencies go, there's just so many factors at play. Certainly you could say, the Federal Reserve looks like it's tightening monetary policy to a greater extent than a lot of foreign central banks are; that should strengthen the dollar.
But we've already seen a lot of strengthening of the dollar. So, it's hard to say exactly what's baked into current exchange rates and what future changes in relative inflation rates, relative interest rates, relative economic growth, and all of these factors that are gathered up into exchange rates. It's very hard to say what's being baked in currently and what's going to be baked in in the future.
So, it's an issue worth worrying about. I think you do need to demand a slightly higher expected return in constant currency terms to compensate for taking on that currency risk. It wouldn't be worth owning a global consumer staples company unless you expect, on a constant currency basis, that it's going to deliver superior total returns than a more domestically focused company where you're not taking on that currency risk. It's a risk like any other that you want to be compensated for, but it's not something that I try to predict going forward, what the currencies are going to do.
In general, the name of the game, again, is just making sure you have diversified exposure and that you're not taking on too much exposure to any given currency or to the strengthening of the U.S. dollar. I think we have a fair bit of exposure to that, again, especially in the Tortoise Portfolio, where we own more global consumer staples kinds of companies, but we try to mitigate that exposure as much as possible by also owning companies that are more domestically focused and limiting our weightings in those companies that have very significant currency risk.
Glaser: Finally, let's take a look at valuation. Are investors being paid to take these risks today?
Coffina: Valuations really are the key question. What's already being baked into stock prices? Is there a margin for error or margin for things to get worse than you're expecting? And I'd have to say at current stock prices, I don't see much margin of safety. I think stock prices are baking in a fairly optimistic scenario.
Partly that's due to the low interest rate environment, but also investors just seem to be very complacent about all of these risks--everything from the geopolitical risks, to the threat of rising interest rates, to relatively sluggish economic growth. The U.S. has seen stronger economic growth than the rest of the world, but still really nothing to write home about in terms of domestic economic growth.
It's hard to say why stocks should be trading where they are, which is a rich multiple relative to longer-term normalised earnings. The kind of valuation we see right now in the S&P 500 is a valuation that we've only seen really three times in history if you look at, for example, the Shiller price-to-earnings ratio--which is one of my preferred metrics: The market is trading at a similar level to where it was before the financial crisis. It also traded at this high of a multiple in the late Nineties leading up to the dotcom bubble, and then of course leading up to the 1929 crash.
Those are really the only three times in history that the S&P has traded at the kind of Shiller price-to-earnings ratio that we're seeing right now, and that's certainly not an encouraging historical track record.
That's not to say stocks are headed for any kind major decline, but I do think investors need to moderate their return expectations. It's very unlikely we're going to see double-digit total returns going forward over the long run--10, 20, 30 years into the future--it's very unlikely we're going to see double-digit total returns. I'd say maybe 6% to 8% is probably sustainable from a current valuation level, and there is also an elevated risk of some kind of major drawdown if things don't pan out quite as investors are hoping.
Glaser: Matt, thanks for your thoughts on these risks today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
