Wednesday, October 27, 2010

Grantham's Night Of The Living Fed!

Here is a great editorial.

  • To Summarize

    1) Long-term data suggests that higher debt levels are not correlated with higher GDP growth rates.

    2) Therefore, lowering rates to encourage more debt is useless at the second derivative level.

    3) Lower rates, however, certainly do encourage speculation in markets and produce higher-priced and therefore less rewarding investments, which tilt markets toward the speculative end. Sustained higher prices mislead consumers and budgets alike.

    4) Our new Presidential Cycle data also shows no measurable economic benefi ts in Year 3, yet point to a striking market and speculative stock effect. This effect goes back to FDR, and is felt all around the world.

    5) It seems certain that the Fed is aware that low rates and moral hazard encourage higher asset prices and increased speculation, and that higher asset prices have a benefi cial short-term impact on the economy, mainly through the wealth effect. It is also probable that the Fed knows that the other direct effects of monetary policy on the economy are negligible.

    6) It seems certain that the Fed uses this type of stimulus to help the recovery from even mild recessions, which might be healthier in the long-term for the economy to accept.

    7) The Fed, both now and under Greenspan, expressed no concern with the later stages of investment bubbles. This sets up a much-increased probability of bubbles forming and breaking, always dangerous events. Even as much of the rest of the world expresses concern with asset bubbles, Bernanke expresses none. (Yellen to the rescue?)

    8) The economic stimulus of higher asset prices, mild in the case of stocks and intense in the case of houses, is in any case all given back with interest as bubbles break and even overcorrect, causing intense fi nancial and economic pain.

    9) Persistently over-stimulated asset prices seduce states, municipalities, endowments, and pension funds into assuming unrealistic return assumptions, which can and have caused fi nancial crises as asset prices revert back to replacement cost or below.

    10) Artifi cially high asset prices also encourage misallocation of resources, as epitomized in the dotcom and fi ber optic cable booms of 1999, and the overbuilding of houses from 2005 through 2007.

    11) Housing is much more dangerous to mess with than stocks, as houses are more broadly owned, more easily borrowed against, and seen as a more stable asset. Consequently, the wealth effect is greater.

    12) More importantly, house prices, unlike equities, have a direct effect on the economy by stimulating overbuilding. By 2007, overbuilding employed about 1 million additional, mostly lightly skilled, people, not counting the associated stimulus from housingrelated purchases.

    13) This increment of employment probably masked a structural increase in unemployment between 2002 and 2007, which was likely caused by global trade developments. With the housing bust, construction fell below normal and revealed this large increment in structural unemployment. Since these particular jobs may not come back, even in 10 years, this problem may call for retraining or special incentives.

    14) Housing busts also help to partly freeze the movement of labor; people are reluctant to move if they have negative house equity. The lesson here is: Do not mess with housing!

    15) Lower rates always transfer wealth from retirees (debt owners) to corporations (debt for expansion, theoretically) and the fi nancial industry. This time, there are more retirees and the pain is greater, and corporations are notably avoiding capital spending and, therefore, the benefi ts are reduced. It is likely that there is no net benefi t to artifi cially low rates.

    16) Quantitative easing is likely to turn out to be an even more desperate maneuver than the typical low rate policy. Importantly, by increasing infl ation fears, this easing has sent the dollar down and commodity prices up.

    17) Weakening the dollar and being seen as certain to do that increases the chances of currency friction, which could spiral out of control.

    18) In almost every respect, adhering to a policy of low rates, employing quantitative easing, deliberately stimulating asset prices, ignoring the consequences of bubbles breaking, and displaying a complete refusal to learn from experience has left Fed policy as a large net negative to the production of a healthy, stable economy with strong employment.

Grantham's view on emerging markets

  • 3) How far can emerging equities go?

    I have been showing late-career tendencies to wander off the reservation of pure historical value. The “Emerging Emerging Bubble” thesis of 2½ years ago (1Q 2008 Quarterly Letter) is in splendid shape. The idea is that within a few more years, emerging equities will sell at a substantial premium P/E because their much higher GDP growth (6% compared to2%) will give a powerful impression of greater value. Everyone and his dog are now overweight emerging equities, and most stated intentions are to go higher and higher. Emerging markets are admittedly fully priced, but they still sell at a decent discount to the 75% of the S&P 500 that are not quality stocks – a particularly strange quirk in a strange market. With their high commodity exposure, their strong fi nances, and their strong GDP growth especially, I believe that they will sell at a premium to the S&P, perhaps a big one. How much of this premium to go for depends on an investor’s commitment to pure value relative to the weight that is placed on behavioralism – the way investors really behave versus the way they should behave. This gives us quite a wide range for investing in emerging that might be considered reasonable. GMO will make its own decision on how “friendly” to be toward emerging market equities as a category. You must make yours.

His recommendations

  • Very Brief Recommendations

    1) Emphasize U.S. quality companies, which are still cheap in an overpriced world.

    2) Moderately overweight emerging market equities.

    3) Moderately underweight the balance of global equities.

    4) Heavily underweight lower quality U.S. companies.

    5) Carry extra cash reserves for a volatile market with insecure fundamentals.

    6) For the very long term (20 years) overweight resources, particularly if they have a sharp decline. (This is my personal view rather than that of GMO, which on this topic is agnostic.)