Can he go any lower?
In his latest quarterly letter to shareholders (does 4,000 words still qualify as a letter?), GMO’s chief market pessimist Jeremy Grantham (left) reviews new data related to “likely lower GDP growth,” the investment implications that might come with “lower GDP growth,” and reaction to his letter from last quarter, specifically about his outlook for “lower GDP growth.”
It’s hard to believe he actually considers it to be a positive outlook. He begins with validation of his previous predictions.
“Some information came out after the 4Q 2012 letter or was missed by us and is worth mentioning,” Grantham notes. “First, the Congressional Budget Office slashed its estimate of the U.S. long-term growth trend from 3.0% to 1.9%! Given the source and the magnitude of the adjustment, I think it is fair to say that their number is ‘close enough for government work’ to our 1.5%.”
But will lower GDP growth necessarily lower stock returns? Surprisingly, Grantham “break[s] ranks” with other pessimists because he believes “theory and practice strongly indicate that lower GDP growth does not directly affect stock returns or corporate profitability.”
What about lower real rates? Will they lead to lower stock returns?
“Economic theory can’t get everything completely wrong,” he writes in typical Grantham fashion. “[P]erhaps one thing economists have gotten partly right is that the risk-free rate has some relationship to the growth rate of the economy. If that rate approaches zero, there is clearly less demand for new capital; in fact, given accurate depreciation accounting, there would be zero net new capital required. It is also easy to see the risk-free rate settling at something around nil. The risk premium, however, might be little affected. The demand for risk capital … would still require that the investor expect an adequate return. If it looked likely to be less than that, he would of course withhold his capital until inevitable shortages pushed up profits enough for the corporation to get a satisfactory return, as we have often discussed.
“However, and I bring up this complicated issue with trepidation,” he concedes, “it does seem possible that in a world with both lower growth and a lower risk-free rate that the risk premium might also drop a little.”
Noting that last quarter's low growth estimate caused a stir, Grantham defends it by saying it was only produced as “a necessary backdrop to show the potential significance of our two new points: the large deduction for a cost squeeze from resources (0.5%) and a very slight but increasing squeeze from climate damage (0.1% rising to 0.4% after 2030), which latter deduction is considered almost ludicrously conservative by that handful of economists that study the costs of climate change.”
“Where on earth did GMO get its pessimistic population data?” read one complaint from a shareholder.
Grantham wouldn’t be Grantham without going after Ben Bernanke and the Federal Reserve, and he doesn’t disappoint.
“The Fed’s negative real rates regime, designed to badger us into riskier investments in order to push up equity prices and grab a short-term wealth effect (that must be given back one day when least comfortable and least expected), has gone on for a long and, for me, boring time.”
So what are some of these effects, he rhetorically asks?
- The artificially low T-Bill rates first work their way slowly up the curve.
- Next, the most obviously competitive type of equities—high-yield stocks—begin to be bid up ahead of the rest of the market, as has happened. “I’ve just got to squeeze out some higher rates somewhere, anywhere,” is the pension fund plea.
- Then, this low-rate competition begins to filter into other securities, historically sought after for their higher yields: higher-grade real estate, where the “cap rates” slowly fall; and, unfortunately, also forestry and farmland, mainly of the larger and more standard varieties that appeal to institutions, which show declines in their required yields, i.e., their prices rise. The longer the engineered rates stay below true market rates, the higher asset prices become until, yes, you’ve got it, corporate assets begin to sell way over replacement cost.
- Then, if the heart of capitalism is still beating at all, a long period of overinvestment begins and returns are bid down and everything moves into balance, often helped along if asset prices get too high, as in 2000 and 2007, by a good, healthy market crunch.
As for the investment implications of all he has to say, he concludes that "courtesy of the above Fed policy, all global assets are once again becoming overpriced," which reminds him of the idea sometimes attributed to Einstein that a workable definition of madness is constantly repeating the same actions but expecting a different outcome.
“But, as always, asset prices are not uniformly overpriced: emerging markets and, we believe, Japan are only moderately overpriced,” he writes. “European stocks are also only a little expensive, but in today’s world are substantially more risky than normal. The great global franchise companies also seem only moderately overpriced. Forestry and farmland, which is not super-prime Midwestern, is also only moderately overpriced but comes with our nook and cranny sticker attached. But much of everything else is once again brutally overpriced.”
He points specifically to U.S. stocks (ex “quality”) in this regard, which now sell at a negative seven-year imputed return on GMO's numbers and most global growth stocks are close to zero expected return.
“As for fixed income—fugetaboutit!” he concludes. “Most of it has negative estimated returns on our data, and longer debt, as always, carries that risk that may be slight in any period, but is horrific if it occurs—accelerating inflation.”