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January 27, 2017 at 10:27 AM
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.
What’s Next?
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.
Limbo Land
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.
