Investors and advisors have plenty of questions about where the markets are heading under President Donald Trump’s leadership.
Ben Inker, head of asset allocation for money manager Grantham, Mayo, Van Otterloo & Co., dissects the economic scenarios that could guide the markets and its participants over the next four years in his latest quarterly report.
Like his bearish partner Jeremy Grantham — who debates if workers will get the economic benefits of their votes in his quarterly letter — Inker seems pessimistic: “The new administration’s plan for a large fiscal stimulus seems poorly designed, oddly timed, and very unlikely to produce the sustained strong growth that Trump claims he will provide.”
But Inker outlines the varied economic shifts that could make such growth possible, along with explaining what factors may lead to dire economic straits during the Trump years.
“Even in the unlikely possibility that we do achieve the growth Trump is calling for, it is not obvious that it would be the boon to the stock market that investors seem to think,” the portfolio manager explained.
“The fiscal stimulus does, however, seem likely to lead to tighter monetary policy and has a reasonable chance of leading to rising inflation. How the economy responds to these two potential outcomes will tell us a good deal about whether [a] Hell or Purgatory scenario is correct, which will be helpful to investors even if the policies themselves prove not to be,” he wrote.
Driving markets upward in recent years have been low short-term interest rates, he explains, asking: Will cash rates shift and like the “old normal” of 1 to 2% above inflation, or they will stay around the average of the last 15 years, about 0% after inflation?
If they average 0% real, we have a “Hell” scenario. A shift back to 1 to 2% above inflation is “Purgatory.”
In November, the U.S. 10-year Treasury Note was yielding about 1.55%, suggesting the bond market was “very much in the Hell camp.”
At year-end, the yield moved up to 2.45%, nearer to Purgatory.
As for whether or not GMO’s leaders have changed their outlook on the likelihood of Hell, the short answer is they have not, Inker says.
“If Hell is a permanent condition for markets, it should not be readily changeable by the policy choices of a single U.S. administration, to say nothing of the fact that we do not yet know what those policy choices will be for an administration that has just taken office,” he explained.
Inker, however, says we are really in a state of uncertainty or “Limbo.”
As he sees it, the Trump administration has not removed the possibility of Hell from GMO’s investment forecasts, but it has given the group “some hope that we may be able to figure out whether we are in Purgatory or Hell within the next few years,” which would get us out of Limbo.
If those who believe we are in a period of secular stagnation are right and equilibrium interest rates have fallen far, we could “see rising interest rates slow the economy considerably, and the Federal Reserve will find itself unable to raise rates as much as it is planning to.”
The economy could then slide back into a recession, prompting rates to come fall, or we might “settle into such a precarious low-growth mode that it will stop raising rates by the time we get to 2% or so on Fed Funds.”
This outcome, Inker says, “would be at least suggestive that we are in Hell.” Still, ending up in recession in the next few years “is not an ironclad guarantee we are in Hell.”
The current expansion is “getting pretty old,” he adds.
This could shift on the down side if Trump’s protectionist rhetoric is put into action and leads to a global trade war, pushing the economy back into a recession.
If monetary policy “doesn’t matter,” as some economists argue, the economy could move along through the Fed’s gradual rate rises “without too much trouble,” according to Inker.
“We probably will begin to read analyses of the financial crisis and the years after which suggest that while some of the emergency measures helped to get the banking system functioning again in the immediate aftermath of the crisis, quantitative easing and ultra-low interest rates did not do that much for the economy in the end,” he wrote in his quarterly letter.
If the economy remains “reasonably strong,” the federal funds rate is likely to rise at least to around 3% and even higher.
Higher rates, of course, will push up bond yields; higher bond yields will provide some competition for stocks; and the higher cost of debt will likely discourage companies from taking on more debt for stock buybacks.
Price-to-equity ratios may “come back down to levels consistent with their longer history of somewhere in the middle to upper teens,” the GMO executive said. “Investment portfolios will take a hit, but we will at least be back to a level of valuations where investors can expect to earn the kinds of returns they need in the long run. It will be Purgatory, and while Purgatory is painful, it is finite.”
A Trump Success?
But what happens if the U.S. economy achieves sustained growth of 3.5 to 4%? A massive reacceleration of productivity, which could support such growth, “seems unlikely,” according to Inker.
“Attempting to grow a 1.5 to 2% economy at 4% is a recipe for inflation,” he said. Rising inflation means “far faster interest rate increases than is generally being priced in, and we will likely learn relatively quickly whether the economy can withstand those increases,” Inker wrote.
In terms of equity investors, it seems nearly impossible that the right interest rates for 5% economic growth would be 0% in real terms. “So Hell, in that case, would seem to be off the table, and with it a big part of the justification for higher P/Es for the stock market,” he stated.
Inker gets even more pessimistic: “Our best guess is actually that faster growth might well be associated with a stock market trading at significantly lower valuations than today. The 1960s and 1996-2005 periods may have been the halcyon days of productivity in the U.S., but it is the current period that has been best for profitability.”
Wages are another important consideration, since it can be argued that sustained strong economic growth requires labor getting more of its share to boost consumption.
“This would almost certainly require corporate profits to fall as a percent of GDP. And if profit margins fall materially, even a moderate acceleration of revenue growth would lead to falling, not rising, overall profits,” Inker explained.
Tax cuts, he argues, have not theoretically or empirically been important to profitability. When tax rates fell in the 1980s, the profit spike came “a good 20 years later,” and historic analysts shows tax rate falls “have generally been associated with falling, not rising, profits,” Inker said.
According to GMO, if Trump’s policies work or demonstrate that we are not stuck in secular stagnation, this will be generally “bad for stocks and bonds and good for the economy.”
A return to a recession should be “good for bonds and not necessarily terrible for stocks because valuations can stay high, buoyed by low cash and bond rates,” Inker says.
The portfolio manager explains that there is “a meaningful plus side to what Trump is doing” — we should “learn some useful things about the economy and therefore where valuations will wind up in the coming years.”
Neither Hell nor Purgatory are great places for investors, but either one is “arguably better” than Limbo.
“We are still putting the higher probability on the Purgatory outcome, which implies that rising rates will not kill the economy,” he said, though GMO also is preparing for other outcomes.
What is the team doing today to build a portfolio that may survive either scenario?
It’s focusing on the following:
- Emerging market value stocks
- Alternatives such as merger arbitrage
- EAFE value stocks
- U.S high-quality stocks
- TIPS for multi-asset portfolios
— Check out Purgatory or Hell? What GMO’s Inker Sees on Horizon for Investors on ThinkAdvisor.