QUARTERLY LETTER July 2010 Summer Essays 1 Portfolio Outlook and Recommendations - Page 1
2 Finance Goes Rogue (But Volcker Wins a Round!) - Page 3
3 The Fearful, Speculative Market - Page 4
4 Everything You Need to Know About Global Warming in 5 Minutes - Page 7
5 “Seven Lean Years” Revisited - Page 9
6 Aging Populations, Pensions, and Health Costs - Page 11
GMO 1 Portfolio Outlook and Recommendations Well, I, for one, am more or less willing to throw in the towel on behalf of In? ation. For the near future at least, his adversary in the blue trunks, De? ation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the “? ation” issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increase dramatically, given the? oods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and in? ation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or? at prices are the prospect for the immediate future.
The worrying news is that most European countries, led by Germany (not surprisingly in this case), are coming on more like Hoover than Keynes. More surprisingly, Britain and half of the U.S. Congress are acting sympathetically to that trend, which is to emphasize government debt reduction over economic stimulus. Yet, after a relatively strong initial recovery, the growth rates of most developed economies are already slowing, despite the immense previous stimulus. You don’t have to be a passionate follower of Keynes to realize that to rapidly reduce de? cits at this point is at least to? irt with a severe economic decline. We can all agree that we had a? nancial crisis, a drop in asset values, and an economic decline, all three of which were global (although centered in the developed countries), and all three of which were the worst since the Great Depression. All three were destined to head a whole lot deeper into the pit without the greatest governmental help in history, also global. Yet despite this help, the economic recovery was merely adequate, unlike the stock market recovery, which was sensational and, as often happens, disproportionate to the fundamental recovery. But in the last three months, more or less universally in the developed world, there has been a disturbing slackening in the rate of economic recovery. (Perhaps Canada and Australia on their own look okay, propped up by raw materials and, so far, un-popped housing bubbles.)
I am still committed to my idea of April 2009 that there would be a “last hurrah” of the market, supported psychologically by a substantial economic recovery but then, after a year or so, that this would be followed by a transition into a long, dif? cult period that I called the “seven lean years.” I had, though, supposed that the economic re? ex recovery – how could it not bounce with that? ood of governmental help to everyone’s top line? – would last longer or at least not slow down as fast as we have seen in the last few weeks. And with unexpectedly strong? scal conservatism from Europe and perhaps from us, this slowdown looks downright frightening. I recognize that in this I agree with Krugman, but I can live with that once in a while. However, where I am merely fearful, he is talking about another “Depression.”
Jeremy Grantham 2 GMO Summer Essays – July 2010 At GMO, our asset allocation portfolios, however, are merely informed on the margin by these non-quantitative considerations. They draw their strength from our regular seven-year forecast. Today this forecast (see Exhibit 1) suggests that it is possible to build a global equity portfolio with just over the normal imputed return of around 6% plus in? ation. With our forecast, this can be done by overweighting U.S. high quality stocks and staying very light on other U.S. stocks. At a time when? xed income is desperately unappealing, this, not surprisingly, results in our accounts being just a few points underweight in their global equity position, which is suddenly a little nerve-wracking as the growth of developed countries slows down. A little more dry powder suddenly seems better than it did a few weeks ago, but then again, prices are 13% cheaper. I regret not having seen the light a few weeks earlier. Running at the same rate of change in attitude as both the market and general opinion is both frustrating and unpro? table. But even as global equities approach reasonable prices, I would err on the side of caution on the margin.
Let me give a few more details: just behind U.S. high quality stocks, at 7.3% real on a seven-year horizon, is my long-time favorite, emerging market equities at 6.6%. This is now above our assumed 6.2% long-term equilibrium return. Additionally, my faith in an eventual decent P/E premium over developed equities exceeding 15%, perhaps by a lot, is intact. Emerging equities’ fundamentals also continue to run circles around ours. EAFE equities at 4.9% are a little expensive (6% or 7%) but make a respectable? ller for a global equity portfolio. Forestry remains, in my opinion, a good diversi? er if times turn out well, a brilliant store of value should in? ation unexpectedly run away, and a historically excellent defensive investment should the economy unravel. Otherwise, I hate it.
6.5% Long-term Historical U.S. Equity Return Estimated Range of 7-Year Annualized Returns *The chart represents real return forecasts1 for several asset classes. These forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above. Stocks Bonds Other 1Long-term inflation assumption: 2.5% per year. ±6.5 ±7.0 ±6.0 ±7.0 ±10.5 ±4.0 ±4.0 ±8.5 ±1.5 ±1.5 ±5.5 ±6.5 2.9% 1.1% 7.3% 4.9% 2.9% 6.6% 0.1% -0.8% 2.2% 0.5% -0.4% 6.0% -2% 0% 2% 4% 6% 8% U.S. equities (large cap) U.S. equities (small cap) U.S. High Quality Int'l. equities (large cap) Int'l. equities (small cap) Equities (emerging) U.S. Bonds (gov't.) Int'l. Bonds (gov't.) Bonds (emerging) Bonds (inflation indexed) U.S. treasury (30 days to 2 yrs .) Managed Timber AnnualRealR eturnOver7Y ears Source: GMO Exhibit 1 GMO 7-Year Asset Class Return Forecasts* As of June 30, 2010 2 GMO Summer Essays – July 2010 3 Other Advice Don’t walk in the woods any more than you have to these days. Don’t get sick until September, when medical practitioners’ vacations end.The Girl with the Dragon Tattoo really is as readable as they say, and the movie is even better. The Sharpe series by Cornwell is the easiest read ever and a painless way to pick up some Napoleonic history.
War and Peace is the most self-indulgent, overwritten work ever. There is, though, a great 600-page novel lurking inside it. 4,300 clicks on my Kindle! Have a good summer! Correction I mentioned in last quarter’sLetter that UBS had? red the inestimable Gary Brinson at the peak of the 2000 bull market. This turned out to be incorrect, as Gary was not? red. He and UBS had agreed to his withdrawal for a variety of personal and other reasons some considerable time earlier. No negatives were meant to be applied to Gary. Quite the reverse. Being? red for standing one’s ground for a good cause is always an honorable activity in my opinion. My apologies.
Finance Goes Rogue (But Volcker Wins a Round!) My previous argument in theEconomist debate* was that the 3% of GDP that was made up of? nancial services in 1965 was clearly suf? cient to the task, the proof being that the decade was a strong candidate for the greatest economic decade of the 20th century. We should be suspicious, therefore, of the bene? ts derived from the extra 4.5% of the pie that went to pay for? nancial services by 2007, as the? nancial services share of GDP expanded to a remarkable 7.5%. This extra 4.5% would seem to be without material value except to the recipients. Yet it is a form of tax on the remaining real economy and should reduce by 4.5% a year its ability to save and invest, both of which did slow down. This, in turn, should eventually reduce the growth rate of the non-? nancial sector, which it indeed did: from 3.5% a year before 1965, this growth rate slowed to 2.4% between 1980 and 2007, even before the crisis.
This bloated? nancial system was also increasingly deregulated and run with increasing regard for pro? t and bonus payments at all cost. Thirty years ago, Hyman Minsky could have told you that this would guarantee a major? nancial bubble sooner or later and at periodic intervals into the inde? nite future. This unnecessary explosion in the size of the? nancial world has been a clear example of the potential for dysfunctionality in the capitalist free market system. I have not been a great fan of the theory of rational expectations – the belief in cold, rational, calculating homo sapiens; indeed, I believe it to be the greatest-ever failure of economic theory, which goes a long way toward explaining how completely useless economists were at warning us of the approaching crisis (with a half handful of honorable exceptions). But it would be a better world if their false assumptions were actually accurate ones: if only information?owed freely, were processed ef?ciently, and were available equally on both sides of every transaction, we would indeed live in a more ef? cient and probably better world. The problem that information is asymmetrical in the? nancial business is a serious one. One side of the transaction, say an institutional pension fund, is often at the mercy of the other, say the prop desk of a talented and mercilessly pro? t-oriented investment bank.
The problem of asymmetrical information is compounded by the confusion between the roles of agent and counterparty. I grew up in a world where stocks and other? nancial instruments were traded by the client with a high degree of trust in the agent. Millions of dollars traded on a word, without a tape recording. Somewhere along the way, without any formal announcement of the change, the “client” in a trade mutated into a “counterparty” who could be exploited. Steadily along the way, the agents’ behavior became more concerned with the return on their own trading capital than with the well-being of their clients. One of my nastiest shocks in 45 years was the realization one day in 1985 that we had been ripped off by our then favorite broker on one of the early program trades we were doing. We had supposed we had developed a trusting relationship. We had certainly done many incentive trades that were successful from our point of view. Perhaps, with hindsight, our strong incentives might have merely motivated them to rip off some other client.
* economistevents.pb.feedroom.com Jeremy Grantham, GMO - Summer Essays - 071910 |
