Peter Brown and David Flynn: Why Irish pension savers will need to be wary of Wall Street

There are good reasons that battered Irish pension funds for both those who are still at work and saving toward retirement and those who have already retired should be wary of the outlook for US stock markets — despite the huge rally in recent weeks.
Peter Brown and David Flynn: Why Irish pension savers will need to be wary of Wall Street
Irish pensions are very exposed to Wall Street and US stocks could go into freefall after the pandemic crisis recedes.
Irish pensions are very exposed to Wall Street and US stocks could go into freefall after the pandemic crisis recedes.

There are good reasons that battered Irish pension funds for both those who are still at work and saving toward retirement and those who have already retired should be wary of the outlook for US stock markets — despite the huge rally in recent weeks.

The question many be asking is why should the ordinary Irish person be at all engaged with the gyrations of Wall Street.

But it may surprise many that all pension savings in Ireland have a huge exposure to global stocks, and by definition to US stocks, which account for a huge part of the non-European exposure for Irish pension pots.

We are wary of US stocks for the reasons we will set out here.

US companies have by far been the most aggressive borrowers during the last decade.

Low interest rates have allowed big US companies to borrow cheaply by issuing lots of bond debt.

And in the vast majority of cases they took the proceeds of that corporate debt to buy back shares, which synthetically pushed up their earnings as measured by earnings per share.

That has created something of a Frankenstein on their balance sheets, with US companies carrying loads of debt and needing to pay it back.

When the cycle changes, as it just so suddenly has done, and earnings decline, many companies will need to either borrow more money by issuing more corporate bonds or, by issuing new stock.

If companies issue new debt to pay back the old debt, it will cost them more.

But issuing new shares at a time when earnings are already in decline will heavily weigh on their earnings per share.

This all adds up to the need to issue shares to pay back bon holders, which kills the stock price.

Our argument against US stocks doesn’t end there. Capital poured into the US to tap all those share buybacks.

But the genie is out of the bottle on US share buybacks and we believe we will soon begin to see capital flight out of the US and into Europe and emerging markets soon.

The fact that the US is behind most of Europe in terms of dealing with the Covid-19 health crisis could accelerate the process.

On top of that, capital flight out of the US will be accelerated by dollar weakness.

Before the Covid-19 crisis, interest rates in the US were significantly higher than they were in most other developed markets.

This caused many yield-starved banks and investment funds outside of the US to buy dollars with their native currencies and then buy higher-yielding US government bonds. It worked well for a time as the dollar went up in value and investors enjoyed higher yields. That game is over now.

The interest rate spread between the US and other developed markets has collapsed on the back of US Federal Reserve interest rate cuts and the incentive for foreign money to hold US treasury bonds is gone.

There is an enormous amount of money being printed by global banks — the balance sheet at the Federal Reserve is currently growing at an annualised rate of $34 trillion — and governments are spending big too.

We’ve seen many multiples of the amount of stimulus pumped into the world economy in recent weeks than during the global financial crisis of a decade ago.

That is good news for companies who have decent balance sheets.

It is bad for companies that have a lot of debt to pay back in the coming years, and the US is the poster child in that regard.

This is why we believe European stocks and emerging markets will outperform the US market.

In the short-term, valuations are a poor predictor of future returns but over the long term they are by far the most important factor.

Valuations have been, and still are, very high in the US — of 40 countries, the US ranks as the second most expensive country and is by far the most expensive in developed markets.

Peter Brown and David Flynn are directors of Baggot Investment Partners dflynn@baggot.ie and pbrown@baggot.ie

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