Wednesday, July 21, 2010

Jeremy Grantham's Summer Essay

Some interesting comments from Jeremy Grantham:

  • Portfolio Outlook and Recommendations

    Well, I, for one, am more or less willing to throw in the towel on behalf of Inflation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the “flation” issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or fl at prices are the prospect for the immediate future.

    The worrying news is that most European countries, led by Germany (not surprisingly in this case), are coming on more like Hoover than Keynes. More surprisingly, Britain and half of the U.S. Congress are acting sympathetically to that trend, which is to emphasize government debt reduction over economic stimulus. Yet, after a relatively strong initial recovery, the growth rates of most developed economies are already slowing, despite the immense previous stimulus. You don’t have to be a passionate follower of Keynes to realize that to rapidly reduce deficits at this point is at least to flirt with a severe economic decline. We can all agree that we had a financial crisis, a drop in asset values, and an economic decline, all three of which were global (although centered in the developed countries), and all three of which were the worst since the Great Depression. All three were destined to head a whole lot deeper into the pit without the greatest governmental help in history, also global. Yet despite this help, the economic recovery was merely adequate, unlike the stock market recovery, which was sensational and, as often happens, disproportionate to the fundamental recovery. But in the last three months, more or less universally in the developed world, there has been a disturbing slackening in the rate of economic recovery. (Perhaps Canada and Australia on their own look okay, propped up by raw materials and, so far, un-popped housing bubbles.)

    I am still committed to my idea of April 2009 that there would be a “last hurrah” of the market, supported psychologically by a substantial economic recovery but then, after a year or so, that this would be followed by a transition into a long, difficult period that I called the “seven lean years.” I had, though, supposed that the economic reflex recovery – how could it not bounce with that flood of governmental help to everyone’s top line? – would last longer or at least not slow down as fast as we have seen in the last few weeks. And with unexpectedly strong fiscal conservatism from Europe and perhaps from us, this slowdown looks downright frightening. I recognize that in this I agree with Krugman, but I can live with that once in a while. However, where I am merely fearful, he is talking about another “Depression."

    At GMO, our asset allocation portfolios, however, are merely informed on the margin by these non-quantitative considerations. They draw their strength from our regular seven-year forecast. Today this forecast (see Exhibit 1) suggests that it is possible to build a global equity portfolio with just over the normal imputed return of around 6% plus inflation. With our forecast, this can be done by overweighting U.S. high quality stocks and staying very light on other U.S. stocks. At a time when fixed income is desperately unappealing, this, not surprisingly, results in our accounts being just a few points underweight in their global equity position, which is suddenly a little nerve-wracking as the growth of developed countries slows down. A little more dry powder suddenly seems better than it did a few weeks ago, but then again, prices are 13% cheaper. I regret not having seen the light a few weeks earlier. Running at the same rate of change in attitude as both the market and general opinion is both frustrating and unprofitable. But even as global equities approach reasonable prices, I would err on the side of caution on the margin.

    Let me give a few more details: just behind U.S. high quality stocks, at 7.3% real on a seven-year horizon, is my long-time favorite, emerging market equities at 6.6%. This is now above our assumed 6.2% long-term equilibrium return. Additionally, my faith in an eventual decent P/E premium over developed equities exceeding 15%, perhaps by a lot, is intact. Emerging equities’ fundamentals also continue to run circles around ours. EAFE equities at 4.9% are a little expensive (6% or 7%) but make a respectable filler for a global equity portfolio. Forestry remains, in my opinion, a good diversifier if times turn out well, a brilliant store of value should inflation unexpectedly run away, and a historically excellent defensive investment should the economy unravel. Otherwise, I hate it.