GMO Quarterly Letter 1Q 2015
Breaking Out of Bondage
The Impossible Math Behind Future Bond Returns
by Ben Inker, GMO
The past year has witnessed yet another rally in long-term bonds all around the world. This move has driven long-term bond yields to extremely low levels, in many cases completely unprecedented. The reasons are not particularly mysterious. A combination of low inflation associated with the collapse in commodity prices and quantitative easing has pushed yields ever lower, particularly in Europe, where the list of countries hitting all-time lows in bond yields has hit double digits.
Switzerland, whose bond market is admittedly of more academic than market importance, has claimed the distinction of being the first country in history to have its 10-year bond yield turn negative. At current yields, the utility of long-term government bonds in most investment portfolios is questionable at best. To our minds, any investors who are not required to own long- term government bonds in their portfolios should warmly consider getting rid of them, and those tempted to speculate on the future pricing of bonds may want to consider the benefits of betting that European and perhaps Japanese bond yields will be higher in the future. The obvious question this recommendation leads to is what to do with the money that isnât being put in long duration bonds. We donât believe that investors should use it as an excuse to buy more equities, but do believe that investors should consider both shortening up the duration of their bond portfolios â the low yields on cash today are a decent trade-off against the possibility of significant losses on bonds in the future â and expanding holdings of alternative investments, such as conservative hedge funds, as well. This makes sense for U.S.-based investors, but is even more essential for investors in Europe and Japan.
Itâs been a very good ride
Over the past 30 years, the MSCI World equity index has returned 7.5% above inflation. Readers of GMO Quarterly Letters over the years are probably used to our arguments that the next 30 years are unlikely to be as friendly to equity investors. But this Quarterly will not be making that argument. This is not because we have changed our minds with regards to equities, but because today the equity markets seem to be less oddly priced than the other major asset that most investors have had in their portfolios over the last three decades: government bonds.
Continue reading below ...
Are We the Stranded Asset?
(and other updates)
U.S. Secular Growth: Donkey or Racehorse?
by Jeremy Grantham, GMO
As you know, dear reader, I have been hacking on for several years about the downward pressures on U.S. long-term growth prospects. What amazed me two years ago was to see the authorities, including the Fed, estimating a nearly 3% trend for the U.S., which seemed to me then and now as impossible. Negligible growth in population and man-hours offered to the workforce is the most important brake to growth, with a net drop of fully 1% from the pre-2000 trend. Less capital investment and growing income inequality do not help. But the most underappreciated important factor, in my opinion, is the drag on growth from the loss of sustained cheap energy as oil has moved from a $16/barrel 100-year trend pre-1972 to todayâs approximate $75/barrel trend price.1
The GFC, in contrast, was a temporary factor and one that I believe (on my own, apparently) was given an exaggerated importance. Given these negative factors, I estimated a few years ago that the U.S. trend line growth for GDP was likely to be no higher than 1.5% a year, and perhaps only 1% for Europe and Japan. Well, wheels turn and estimates are re-estimated: official estimates for the longer-term growth trend of the U.S. have been falling slowly but surely over the last few years to a range from 2% to 2.5%. In the two or three years since 2012, I had expected to see them in the range of 1.5% to 2%. Well, into this quiet world of creeping adjustment, an IMF paper released in early April of this year acted as an unexpected jolt of excitement as, unusually, estimates tumbled all the way down to 1.5%.2
Wonders never cease. Now, the question is how much will this affect the Fedâs beliefs? Presumably enough to matter. This would be timely because, as you may remember, I have been anxious about the Fedâs whipping our actual 1.5% donkey in the mistaken belief that it was a 3% racehorse. The danger was, as I said, that they would keep on whipping it until either the donkey turned into a racehorse or dropped dead. Death from overstimulation.
Continue reading below ...
Read/Download the complete report below, or here:
