GMO Second Quarter Shareholder Letter - Part 2

Jeremy Grantham describes "10 quick topics to ruin your summer"

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Oct 06, 2015
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Risk parity

Another group of price-insensitive investors are managers of risk parity portfolios. These portfolios make allocations to asset classes not with regard to pricing of assets, but rather their volatility and correlation characteristics. Their price-insensitivity comes out in a couple of ways. First, as money flows into the strategies, they are levered buyers of bonds and inflation-linked bonds in particular. Like most strategies, if the money flows out, they are forced sellers of a slice of their portfolio. Second, unlike many other investors, they will also tend to buy and sell based on changes in volatility. As the volatility of an asset falls, these strategies will tend to lever it up further, and as the volatility rises they will sell. Given that low volatility tends to be associated with rising markets and high volatility with falling markets, this gives their buy and sell decisions a certain momentum flavor. If bond prices are moving up in a steady fashion, they will tend to buy more and more as volatility falls, and in a disorderly sell-off that sees yields and expected returns rise along with rising volatility, they will sell the assets due to their higher “risk.” In fact, rising volatility in bond markets could cause a general delevering of risk parity portfolios, causing them to sell assets unrelated to bonds in order to keep their estimated volatility stable. With hundreds of billions of dollars under management in risk parity strategies and large holdings in some of the less deeply liquid areas of the financial markets such as inflation-linked bonds and commodity futures, it is easy to imagine their selling in unsettling markets under certain circumstances, such as a repeat of 2013’s “Taper Tantrum.”

Traditional mutual funds

While the levered nature of risk parity portfolios may cause them to punch above their weight in potentially disrupting markets, in the end it isn’t clear that they are more likely to cause trouble than the managers of traditional mutual funds.

The mutual funds are at the mercy of client flows. As money has flowed into areas such as high yield bonds and bank loans, they have had little choice but to put it to work, and given their mandates, prospectus restrictions, and career risk, they are largely forced to buy their asset classes whether or not they think the pricing makes sense. But to an even greater degree, when redemptions come, they have no choice but to sell. This is nothing new. But what has changed is the extent to which mutual funds have seen large flows into increasingly illiquid pieces of the markets, particularly in credit, where bank loan mutual funds are 20% of the total traded bank loan market and high yield funds make up another 5%. That may not sound particularly large, but almost half of that market is made up of CLOs, which are basically static holders of loans. This makes the “free float” of the bank loan market perhaps half of the total, and should the bank loan mutual funds sell, there are not a lot of investors for them to sell to.

This is particularly true given the changes to the regulatory landscape for the dealer community. Banks are much less likely to take bonds and loans on their balance sheet for any length of time in the course of their market-making activities. This is true for all sorts of securities – given new regulations such as the Supplementary Leverage Ratio Rule, which started coming into effect early in 2015, even very safe securities such as Treasury Bills can require expensive capital charges for dealers to hold onto. The banks’ willingness to hold significant inventory of low-rated, less liquid instuments such as high yield bonds and bank loans is a fraction of what it was prior to the financial crisis.

Conclusion

The size of the price-insensitive market participants is impressive. Monetary authorities and developed market central banks have each bought on the order of $5 trillion worth of assets for reasons that ultimately have nothing to do with earning an investment return on them. Regulatory pressures have caused pension funds, insurance companies, and banks to do likewise. While it is somewhat harder to put precise numbers to the size of these investments, it seems a safe bet that the total is in the trillions as well. Other investors are in analagous positions for different reasons, as strategies such as risk parity and the exigences of life as a mutual fund portfolio manager push such investors to also buy assets for reasons other than the expected returns those assets may deliver. To date, these investors have tended to be buyers, and given their lack of price-sensitivity, they have pushed up prices of assets beyond historically normal levels.

At the same time, a natural buffer for many markets against a temporary imbalance between buyers and sellers, the dealer community has been forced to significantly curtail its activities due to the regulatory regime. So if circumstances cause these price-insensitive buyers to turn around and become price-insensitive sellers, there are not a lot of candidates to take the other side. As instrumentagnostic, price-obsessed value investors, we stand ready to buy should the virtuous cycles turn vicious and prices in some disrupted market become compelling to us. However, our paltry few billions of firepower pales in comparison to the trillions of dollars that have pushed markets up, and might, just possibly, push them back down. Be prepared for the possibility that some of the same assets that have again and again risen to prices that many investors said were impossible show more downside volatility than investors have bargained for.

So, what are we doing today in our portfolios to prepare for this possibility? In an “offensive” sense, not a lot, as it is very difficult to position a portfolio for an uncertain future event occurring in one or more asset classes at an undetermined time. But a couple of things are clear. First, to paraphrase my colleague James Montier, when you are uncertain about the future, don’t position your portfolio as if you were certain. Today we are making sure not to be so large in any asset class that we would not be comfortable increasing our exposure to it if its valuation fell significantly. Beyond that, we are trying to retain our flexibility to react to market gyrations by holding a significant amount of cash as dry powder. In a world where we could be confident that the price-insensitive buyers would stay buyers and valuations stay high, that cash would feel like a painful drag on performance. Today it feels like prudent flexibility in a world where the pressures on markets might well reverse in a way few are banking on.

Ten Quick Topics to Ruin Your Summer

Introduction

I have always had a much more interesting job than average in the investment business, with an enviably large chunk of my time to examine what I chose to. But, still, there was quite a bit of boring maintenance work needed to support the brainstorming or pure reflective time. Such time is, in my opinion, the backbone of a creative organization and it should be highly protected, but in real life you have to fight for it and you should, for we all know how quickly maintenance work can eat into our thinking time.

Well, the good news for me is that I now have an ideal job in which almost no maintenance work is required, and I have no routine day-to-day responsibilities. I am consequently free to obsess about anything that seems both relevant and interesting, which for the time being has come down to 10 topics that really matter, at least in my opinion. They can all be viewed as problems: potential threats to our well-being. I admit this is lopsidedly negative, but surely it is more important to obsess about threats, which we often prefer to ignore. Good news, in contrast, will usually look after itself. Trying to keep abreast of all of these topics would be at least a full-time job for the average reader, as it is for me, for some are changing very rapidly indeed. So for this summer’s quarterly, I have decided to very briefly summarize all 10 topics; to cover some interesting new research on several of them; to review one or two older but potentially important research projects that slipped through in the past with much less attention than seems appropriate; to discuss one or two pennies that have recently dropped for me; and, finally, to highlight a few new pieces of interesting data on several of these topics. So, here we go…

1. Pressure on GDP growth in the U.S. and the balance of the developed world: count on 1.5% U.S. growth, not the old 3%

2. The age of plentiful, cheap resources is gone forever

3. Oil 4. Climate problems

5. Global food shortages

6. Income inequality

7. Trying to understand deficiencies in democracy and capitalism

8. Deficiencies in the Fed

9. Investment bubbles in a world that is, this time, interestingly different

10. Limitations of homo sapiens

Recap

Factors potentially slowing long-term growth:

a) Slowing growth rate of the working population

b) Aging of the working population

c) Resource constraints, especially the lack of cheap $20/barrel oil

d) Rising income inequality

e) Disappointing and sub-average capital spending, notably in the U.S.

f) Loss of low-hanging fruit: Facebook is not the new steam engine

g) Steadily increasing climate difficulties

h) Partially dysfunctional government, particularly in economic matters that fail to maximize growth opportunities, especially in the E.U. and the U.S.

Comments

Mainstream economists, with their emphasis on highly theoretical models, have been perplexed by the recent chain of disappointments in productivity and GDP growth and would disregard all or most of these factors as theoretically unsatisfactory.

I am impressed by how many of these factors intersect with the important problems I obsess about. This might offer a reason for taking them more seriously, for few things could be more important background information for any market analyst than to have been prepared for a steady diet of topline disappointments.

Added Thoughts

After every historical major rally in commodity prices, there has been the predictable reaction whereby capacity is increased. Given the uncertainties of guessing other firms’ expansion plans, the usual result is a period of excess capacity and weaker prices as everyone expands simultaneously. The 2000 to 2008 price rally was the biggest in history, above even World War II. It was therefore not surprising that the reflex this time was the mother of all expansions and excess capacity. This was further exaggerated by a sustained slowdown in demand from China, which is still playing through. The most dramatic example of this was in China’s use of coal, which had grown from 4% of world use in 1970 to 8% in 1988 and to 50% in 2013, the world’s most remarkable expansion in the use of anything since time began. And yet this remarkable surge was followed in 2014 by a reduction in China’s use of coal! And that in a year in which China was still growing at over 6%.

So, how profound was this supply surge and price decline? Exhibit 1 shows our original index, which is made up of 33 important commodities equally weighted to avoid the data being overwhelmed by oil, which constitutes around 50% of all tradable value in commodities. You can see that although the average price has declined handsomely, it has only given back about one-third of the preceding great price surge. And now with a further sell-off in commodities following China’s recent mini stock bust, the reaction phase may be more or less complete: projects have been cancelled and capital spending plans in general have been savaged. Investment attitudes are extremely negative, which is, as always, a requirement for change. Today’s Wall Street Journal (July 21, 2015) carries a headline: “Investors Flee Commodities.” Promising. From now on it seems likely that prices will be more mixed, with some rising as others continue to fall. What seems extremely unlikely, assuming we have no global depression, is a return to the declining price trend of the 100-year period ending in 2000.

In agriculture, we also had a global sell-off following three consecutive years in which extremely hostile grain-growing weather had driven prices to panic levels of triple and quadruple their previous lows. Good, unused arable land was scarce, but most of what could be thrown into battle was. And, as I suggested three years ago (for which I took some grief), investors should have counted on less bad weather inevitably arriving, perhaps even above-average conditions, which for the last two years has occurred. Yet although grain prices are way down (approximately -40%) from their panic shortage highs of 2011, they are still way up (approximately +70%) from their 2000 lows. And bad weather will be back: it has been bad here, there, and everywhere recently (California’s drought, notably) except for major grain-growing areas.