Risk Latte - On Jeremy Grantham and Why Bonds?

On Jeremy Grantham and Why Bonds?

Aditya Rana
August 28, 2010

It sure has been an interesting summer for global financial markets, which after peaking in late April were down about 15% going into July when they proceeded to stage a sharp 7% rally which then fully reversed itself in August resulting in the U.S. markets being down about 6% year to date! Little wonder that hedge funds and proprietary trading desks at banks have had a rough summer and their performance is largely down year to date. During such tumultuous times it pays to take serious note of views of wise old men such as Jeremy Grantham who published yet another great quarterly piece, in the form of six summer essays in July. Without further ado, I summarise below the relevant parts (pertaining to markets) of the essays:

  • The ongoing tussle between inflation and deflation has ended with the winner being the pugilist in the blue corner-deflation! A weak economy and declining or flat prices are the theme for the immediate future.


  • As the effects of the greatest governmental stimulus in history wear out, economies around the world have taken a decided step downwards in terms of growth rates which is rather frightening given the gathering global momentum behind fiscal conservatism (“Austerism”).


  • He still expects one final hurrah of the markets into the next year or so, to be followed by a long difficult period which he terms the “seven lean years”.


  • He has reduced the probability of a “consistently better recovery than expected” scenario to 25%, and to 45% the probability of “markets following the path of least resistance” (with the S&P rising to 1400) fuelled by aggressive risk taking by hedge funds as supported by the Fed through its zero interest rate policy and the existence of a “Bernanke put”.


  • He has increased the possibility of a sharp and quick sell-off of the markets towards fair value (S&P at 900) to 30% in light of recent events . (The quarterly came out in July – i suspect his odds for this scenario would be even higher now!).


  • The unusual market volatility this summer is a result of the ongoing tussle between the highly speculative wings of institutional money and the more conservative half of institutional money which is deeply disturbed by the recent negative global and U.S. economic events.


  • A direct result of this tussle is the significant outperformance of speculative small cap stocks versus quality stocks, despite small cap stocks starting the year at a relatively overvalued level. However, if the market were to experience a sharp sell-off over the next few months this is likely to be quickly reversed into a 10% relative underperformance by small caps.


  • Possible reasons why quality stocks in the U.S. are cheap (and have been for several years): 1) retirees are selling blue chip stocks to pay bills and fund purchases of fixed income instruments, 2) institutions and high net worth individuals have been shifting into alternative assets like hedge funds, private equity, commodities, EM stocks and selling quality stocks and government bonds.


  • His 7 year real per annum return expectations are as follows: U.S. quality stocks: 7.3%, EM: 6.9%, International equities: 4.9%.


  • The "seven lean years" scenario he is expecting is driven by the following factors:


  1. Deleveraging of private debt which is likely to be a slow and painful process and is likely to take about 7 years for debt levels to reach the norm;


  2. The rapid replacement of excessive private debt with excessive government debt poses significant risk.


  3. The stimulus provided by excessive debt and resulting housing and stock bubbles over the past several years is likely not to reoccur for a long while.


  4. While the U.S. may have seen the worst of its financial crisis, Europe remains particularly vulnerable to shocks. In addition, the U.S. financial sector is likely to contribute less to GDP growth than it has over the last few decades.


  5. The runaway costs in the public sector, at the state and city levels, is being reversed through painful cost cutting.


  6. Unemployment is high and likely to remain so for a while, keeping consumer confidence and business spending low.


  7. Global trade imbalances continue to persist and pose risk to the system and therefore need to be corrected which is likely to be painful.


  8. The ongoing intractable problems with the PIGS countries in Europe are likely to produce slower GDP growth and a long workout period.


  9. The rising sovereign debt levels and the particular problems facing the Euro bloc and Japan are leading to a systematic loss of confidence in faith-based currencies.


  10. The final, and probably most important of all, is the very long-term problem of wide-spread over commitments to pensions and health. “We all face the choice of reneging or rewriting the social contract”.


Jeremy Grantham paints a rather bleak picture of the developed world over the next seven years, and with good reason. As i have pointed out in previous newsletters, the structural bear market which began in 2000 has 5 to 7 years more to go as the developed economies tackle their problem of excessive debt and its myriad insidious effects on the economy and markets. However, there are likely to be strong market (and economic) rallies in the interim, providing opportunities to make good returns provided one is able to keep a disciplined focus on long-term valuation parameters and cast a sceptical eye on the false hopes and hype spouted by a majority of the media and the perma-bulls.

My take on his market scenarios is a high probability (60%) of a sharp fall towards fair value (S&P at 900) into October/November followed by a “last hurrah” rally which may last 12 to 18 months. Increasing expectations of a negative print on the 3rd quarter GDP to be released end-October, combined with the heightened political tensions going into the mid-term U.S. elections in early November, are likely to be the leading causes for the sharp and quick decline in markets. This is likely to cause a significant quantitative easing announcement (“QE2”) by the Fed (at its November 2-3 meeting) to be followed by a second fiscal package leading to the commencement of a market rally into year-end and 2011. EM stocks, bonds, currencies and commodities are likely o follow developed markets in this scenario, but with higher beta (i.e. a larger initial fall followed by a larger subsequent rise). The dollar is likely to be stronger under this scenario.

Why Bonds?

Long dated U.S. Treasury bonds have been one of the best performing asset classes this year providing a total return of 20-30% year-to-date (the lower end of the range being coupon bonds and the higher end being zero coupon bonds). Yet i continue to be amazed by the wide-spread lack of knowledge about bonds as an asset class, among even finance professionals and so called investment gurus. To provide a recent anecdote: I was taking afternoon tea (white-tipped darjeeling in delicate bone china cups-what else is there to drink!) at my favourite tea spot in Hong Kong with an old friend who is an experienced banker. I was discussing an excerpt of a monthly report by the inestimable Gary Shilling (and another “wise old man” ) , one of the most astute observers of the bond market (and markets in general) and who called the current 29 year bull market in bonds in 1981 – and predicted that long term bond yields will eventually from 14.7% to 3% (he also called the bursting of the Japanese bubble in the late eighties, the internet bubble in the late nineties and the housing bubble in 2007-not a bad track record!).

The excerpt went as follows “$100 invested in a 25-year zero coupon bond at the yield high in October 1981, and rolling it into another 25-year zero coupon bond annually to maintain its 25-maturity, would have grown to $16,695 by June 2010 with a compounded annual return of 19.5%. In contrast, $100 invested in the S&P 500 at its low in July 1982, was worth $1,997 in June 2010 with dividends reinvested to provide an annual return of 11.2%. So Treasuries outperformed stocks by 8.4 times! Even in the 80’s and 90’s long dated Treasuries way outperformed stocks, during a period which recorded the longest and the strongest bull market on record”. This data left my friend absolutely amazed!

My point with the above is not that we are in the midst of the bull market in bonds – we are nearing the end of this once-in-a-lifetime bull market (and kudos to those who got it right including intrepid observers like David Rosenburg, Paul Krugman, Lacy Hunt & Van Hoisington, John Maudlin, Bob Bronson and the irrepressible Hugh Hendry who all dared to sway against the wind!) but we probably have another 50 basis points (0.50%) more in yield to go (which translates into a 15% capital gain for 30 year zeros) . But with cold deflationary winds blowing, resulting in the Fed continuing its policy of keeping zero short-term rates for an indefinite period, we are unlikely to see a significant back-up in yields making bonds a decent asset class for the foreseeable future. A long term bond yield chart from Doug Short& Chirs Kimble is shown below.



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