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.”