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GMO’s Inker Weighs In on Trump, Bonds, Brexit

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A Donald Trump presidency could profoundly hurt the American economy, according to Ben Inker of GMO, the global investment firm co-founded by Jeremy Grantham, a celebrated market-bubble forecaster.

Though Inker’s name isn’t nearly as well-known, as portfolio manager and co-head of the firm’s asset allocation team he is the person in charge of managing GMO’s $94 billion in client assets.

In a lengthy interview with ThinkAdvisor, Inker, who came to GMO right after graduating from Yale University 24 years ago, talks about the huge risk inherent in a Trump election, a stock market bubble on the not-so-distant horizon, what could easily trigger the next U.S. financial crisis, the impact of Brexit, and emerging markets, among other issues critical to investors and advisors.

Inker, 45, is responsible for allocations of GMO’s multi-asset portfolios and portfolios that invest across equity regions. Clients are chiefly sophisticated institutional investors. For retail investors, the firm is subadvisor for two Wells Fargo funds: the Wells Fargo Asset Allocation Fund (EAAFX) and the Wells Fargo Absolute Return Fund (WARAX), both of which Inker manages.

A member of GMO’s board of directors, he has held a variety of posts during his rise, including chief investment officer of quantitative developed equities.

ThinkAdvisor recently spoke by phone with the Boston-based chartered financial analyst, who has spent his entire career, to date, at GMO.  Where did he get that job lead? From David Swensen, Yale’s longtime CIO and one of his professors. Grantham called asking if Swensen had any students who could be a good fit with GMO. It’s been two dozen years and counting for Inker. Here are excerpts from our interview:

THINKADVISOR: What impact will the presidential election have on the U.S. economy and stock market?

BEN INKER: A government can manage to destroy an economy if it so chooses, and it’s possible that a sufficiently ill-advised set of policies in the U.S. could do profound damage. We now have a candidate for president who is capable of that: It’s very hard to know what a Trump presidency would be like, but some of the things he has said would be really scary. It’s possible that a Trump election would be the exception to the rule that it doesn’t much matter who is U.S. president from an investment standpoint.

What if Hillary Clinton is elected?

Whether she turned out to be a particularly good president or a particularly bad one, it seems unlikely that she’d do anything to change the nature of the U.S. economy in a profound fashion.

Jeremy Grantham is 77. Are you next in line to succeed him?

We aren’t trying to base the firm on having another Jeremy Grantham; and the firm hasn’t set itself up so that, in order for it to succeed, I must be. Jeremy doesn’t have any day-to-day responsibilities for the portfolios. Over time, he gave over his responsibility for the management of client assets. My team and I function independently of him. He comes in every day and is thinking about important investment topics that can have impact on the portfolios. But I am the portfolio manager; he is not.

Do you have lots of meetings with him and then decide how to proceed?

Jeremy is a member of our investment review group, and we meet periodically to talk about big things that are going on. [But] I have the end responsibility for determining what it is we’re going to do.

Do you see any signs of a bubble occurring now?

The U.S. stock market is getting closer to two standard deviations overvalued relative to history [which Grantham defines as a bubble]. But we aren’t quite there yet. Maybe when the S&P is at 2,300 or 2,350, we could plausibly be talking about bubble levels.

What about a bubble in bonds? It’s very hard to call what’s gone on in government bonds a bubble in the normal sense because bubbles are usually characterized by euphoria and very positive emotions, whereas it seems anything but with regard to what’s happened with bond yields.

What impact has Brexit had on your investing?

As people who are attempting to be long-term investors, we think the impact on the true long-term, fair value of most companies whose stocks are traded in the U.K. is just not that big a deal. Nothing happened that was material enough to cause us to say, ”We need to jump in now and do something about it.”

Please talk about the U.S. dollar in light of Brexit.

Brexit didn’t particularly cause the dollar to strengthen since part of the dollar’s strength has been on the back of an assumption that the Fed was in a hiking mode, whereas the rest of the world was absolutely not. Brexit seemed to put Fed hikes on the table.

“U.S. house prices … might beat the U.S. equity market in the race to cause the next financial crisis,” Jeremy Grantham wrote in an update to his Q1 2016 quarterly report.  Do you agree?

Yes, you could easily see housing causing the next crisis. Home prices have now made quite an impressive recovery from their post-financial crisis low but are pretty expensive again. Compared to stocks, a home is an asset owned by a much larger swath of households; for the vast majority of people, it’s their biggest asset and owned with a lot of leverage. So you could imagine a problem in the housing market [caused by] a normalization of interest rates: Some people will find it difficult to pay their mortgages.

So that could precipitate another bubble?

If there are continued increases in housing prices, that could create another bubble and another bust. The contagion of a debt-fueled asset bubble (housing) is much worse than a cash-fueled asset bubble (equities). It generally takes close to a generation for assets to return to bubbleness after a real bust – for people to lose their memory of how painful that was. But markets seem to lose their memory a lot more quickly than they used to.

What’s your outlook for the U.S. stock market for the rest of this year?

We don’t much like the U.S. stock market, [but] the fact that the market is pretty expensive doesn’t necessarily stop it from going up. It’s an overvalued market in a world where most things that are cheaper look scarier — and the things that look lower risk are deeply unappealing, whether cash, government bonds or investment-grade corporate bonds. We don’t think the market deserves to do particularly well. So up or down slightly would be perfectly unexceptional. In all the portfolios where I have an ability to express a view on the U.S. market, my multiyear view is that U.S. stocks are less attractive than stocks in the rest of the world.

Mr. Grantham wrote in his “Immigration and Brexit” report in July that “the U.S. market will hang in or better, at least through the election.” Agree?

The election cycle has had pretty good predictive power. We’re in the fourth year of an election cycle, and [historically] with few exceptions, you tend to have a modestly up and stable year. So now through November, if history is a guide, that’s the best guess. If you own the cheaper stuff, you’ll eventually win. Why is the U.S. market trading at a significant premium to that of the rest of the world?

A big part of it is that the U.S. seems safer. The presidential election aside – bearing in mind what I said about [a Trump election] being the notable exception – somehow the political risks seem less extreme in the U.S. than in some other places. The economy here is doing better. The market has done better. People have trouble imaging the U.S. losing because it has won for a long enough time. When the U.S. does lose again, which will inevitably happen sooner than later, it’s going to come as a nasty shock because right now, people have trouble imagining it.

What do you forecast for earnings growth in the U.S.?

Over the next several years, the U.S. should struggle to see much earnings growth, and profits might well shrink a bit. If the U.S. grows sustainably from here, it’s probably going to be on the back of household incomes and therefore wages growing faster than the overall economy, which means falling profit margins.

What if the economy is weak?

There will probably be falling profit margins on the back of falling sales. So the good news would be gently falling earnings as rising revenues are slightly more than countered by falling sales margins. The bad case would be a recession, where profits would fall more sharply.

What’s your outlook for bonds?

If something happens that causes inflation to be a lot higher or a lot lower than expected, that can give you either a wonderful windfall gain or blow a nasty hole in your portfolio that takes a long time to dissipate.

Your thoughts about high-yield (junk) bonds?

High-yield bonds are probably worth a place in your portfolio today. [But] we owned more high yields this winter and spring than we do now. Yields have gotten to quite attractive levels, but a real concern is that though [investors] are probably getting close to adequately paid for default risk, they’re not getting paid very well because high-yield bonds have become very illiquid assets.

So what specifically are the implications?

We as a firm have concerns that we might well be at the start of a default cycle. Trailing 12-month defaults in high yields in the U.S. have now peaked above the long-term average. A lot of that has to do with energy and mining. We’ve seen very few events in history where we’ve had a move up through the long-term average level that immediately went back down, and things were safe for high-yield investors. So we’ve got some concern that the next few years might be bad from a default-level perspective.

How are high-yield bonds priced compared to Treasuries?

No worse than Treasuries in the event of a bad outcome — and better in the event of something better than that.

You’ve been overweight emerging markets. What’s your take now?

If you talk to investors about emerging markets, in general you get eye rolls, head shakes and, “Oh man, we’ve lost so much money. It’s hard to imagine [emerging markets] turning around.” People have very low expectations for this asset class. And when people have very low expectations for asset classes, good things can happen.

Is that the situation right now?

Our head of emerging markets has long said that the real money there isn’t made when things go to from good to great but when they go from absolutely horrible to merely terrible. So we’re happy holders of emerging market equities today because they’re priced for pretty bad things, and bad things aren’t happening. Looking at Brazil, it doesn’t seem like there’s been a positive headline about it this year. But the Brazilian stock market has been just about the best performing stock market in the world.

What significance does that example have to GMO?

For quite a while we’ve had complaints from our clients that emerging can do well only when the emerging economics are firing on all cylinders and that in the absence of that, emerging is doomed to lose. We don’t believe this. Again, when expectations are really bad, you can get very good returns when merely less horrible things come to be. Do you see less horrible things in the offing?

It hardly takes a stretch of the imagination to think so. We believe emerging markets are priced at a level where if that happens, they can perform. They deserve to make money in real terms, which is exciting in a world where so many assets are priced not to give returns over and above inflation.

Any downside to emerging markets?

We’re still quite worried about the aggregate amount of credit growth in emerging across the last five or six years. We’re still seeing that, certainly, in China. But, all else equal, I’d rather have a cheap market with everybody convinced that nothing good can happen than an expensive market where everybody is convinced all it can do is go up.

Please talk a bit more about China.

Growth in China is worrying. The question is: Can you find stuff to own there that’s relatively safe even in the event of a credit-induced problem, or possibly is cheap enough that even if it isn’t safe in a credit-induced problem, the expectations are so bad for it that it will do OK? Despite our concerns about the economy, there’s stuff worth owning in China.

Broadly, in what market sectors do you see opportunity?

We’re not primarily sector people, but what’s definitely striking today is sector valuations’ variance in different regions of the world. That seems to have a lot to do with how comfortable people are with the local economy.

Can you talk specifics?

In the emerging world, where people don’t have particularly high expectations for growth, or in Europe, some of the more cyclical sectors, such as consumer durables and industrials, look pretty cheap.  In the U.S., where the economy has been fine for a long time and expectations seem to be that it will continue to be, we still like some of the more defensive sectors, though consumer non-durables have done very well, and some of the consumer product companies do look pretty fully valued.

What are your thoughts about oil?

Our best guess is that there isn’t currently enough investment in energy production to meet the world’s oil needs for the next four or five years. So, reasonably, one could see the price of oil creeping up over that period. As you look longer than that, oil, whose overwhelming use is as a transportation fuel, has a meaningful risk of being kind of pushed aside in favor of electric transportation. It’s hard to know exactly whether that’s going to be a big deal in the 2020s or not. But it’s certainly a risk.

Back to Brexit: How will Britain’s leaving the European Union affect the U.S. dollar long term?

Even if Brexit does not have long-term impact on the British economy, one presumes the likelihood of a recession in the U.K. during this period is reasonably high — and they’re not going to raise interest rates into that. So the U.S. dollar might be looking for an excuse to stay expensive, or get more expensive. I’m more confident that seven years from now, the dollar should be cheaper than it is, than I am that a year or two from now, it will have gone down — not up.

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