Apologies for the formatting. Below is the Q2 commentary from the GMO Quarterly Update. The various GMO funds are clearly positioned cautiously and at the end their positioning is detailed.
Apologies for the formatting. Below is the Q2 commentary from the GMO Quarterly Update. The various GMO funds are clearly positioned cautiously and at the end their positioning is detailed. Investors started the year with the nagging feeling that, despite rising asset prices, the real economy was still struggling. In the second quarter that nagging feeling was replaced by the very real danger that the global economy might indeed be stalling, and asset prices began to swoon.
Selective reporting of certain sentiment indicators such as purchasing manager surveys and ISM indices had provided cover at the start of the year for the idea that the global recovery was well underway. By April, however, it was clear that the global recovery was running into some serious trouble. Retail sales, real incomes, unemployment, and industrial production in the developed world all disappointed and suggested that fundamental weaknesses in the real economy persisted. Meanwhile, the ongoing inflationary problems in emerging markets were further compounded by slowing export growth. Taken together, it is hard to avoid the conclusion that quantitative easing and the various monetary measures undertaken by the large central banks held the seeds of their own demise.
While quantitative easing did manage to stabilize risk premiums, it appears to have done so at the cost of rising food, fuel, transport, and import prices. These price increases served to further undermine feeble income gains and ensured that real personal consumption and, hence, final demand, remains weak. In perhaps the cruelest irony of all, weak final demand virtually guarantees that companies have no reason to increase capital expenditures beyond replacement activity.
In stark contrast to its actions of a year earlier, the Federal Reserve in particular practically acknowledged as much as it ruled out further easing programs despite the economic soft patch. In the absence of actual deflation, the Fed seems content to sit on its hands and hope for a pick-up in activity in the second quarter. Unfortunately, there are strong reasons to believe that the anticipated pick-up in activity is a pipedream. In particular, the waning of fiscal stimulus in the U.S. and Japan coupled with fiscal austerity in Europe is removing the one pillar that had supported both incomes and profits. The extent to which global leadership seems determined to follow in the path of the Japanese after the implosion of their asset price bubble is possibly the biggest surprise of the crisis. Japanese policymakers were never able to keep their eyes on the weak economy, instead always eager to turn their attention back to "normalizing" policy – raising interest rates, raising taxes, and cutting spending. The danger today is that potential shocks to the global economy from European debt woes to a Chinese slowdown further shift the balance of probabilities toward an asset price correction.
Despite intra-month volatility that saw the S&P 500 fall during the quarter, a strong rally in the last four days of June meant that the index actually closed with a gain of 0.1%. Dispersion between the Russell 1000 Value and Growth indices was also muted, with growth outpacing value with a return of +0.8% versus -0.5%. Perhaps more heartening in our view, given our harping about small cap valuations, was the failure of the Russell 2000 to outpace the S&P 500 in an albeit modestly rising market. The Russell 2000 returned -1.6% for the quarter.
International indices were more constructive than the U.S., but this was mostly due to dollar weakness. The MSCI EAFE index finished with a gain of 1.6%, but in local currency terms the index actually fell 0.8%. A pattern similar to that of U.S. value and growth was repeated internationally with the EAFE Value index returning +1.0%, failing to keep up with the EAFE Growth index, which rose 2.1%. Emerging market equities continued to underperform, dropping 1.0% by the end of the quarter.
Bond market yields fell significantly, reflecting the ongoing uncertainty associated with European debt woes. In the U.S., the yield on the 10-year benchmark bond fell back below 3% at one point during the quarter, and finished the period at 3.15%. Lower yields translated into a healthy gain of 2.5% for the J.P. Morgan U.S. Government Bond index. Strong returns were also seen internationally, with the J.P. Morgan non-U.S. Government Bond index gaining 3.7% over the same period.
Widening credit spreads, however, meant that the Barclays Capital U.S. Aggregate index posted a more modest gain of 2.3%. The recovering municipal bond market continued apace, with the Barclays Municipal Bond index returning +3.3%. The J.P. Morgan EMBI Global topped the rankings with a return of +4.0%.
Throughout the first four months of 2011, investors around the globe continued to climb a wall of worry, with their speculative zeal trumping any and all concerns surrounding a nasty brew of poor employment numbers, worsening housing markets, rising commodity prices, and dysfunctional European parliaments. And, let's not forget the rolling series of civil wars in the Middle East and North Africa and the nuclear crisis in Japan. In May, however, it was as if – having reached the top of the wall – investors finally took a more serious survey of the landscape and concluded "all is not well." Perhaps it was the looming end of QE2 and all of the unknowns associated with it, or the realization that the Greek debt crisis was merely the tip of a liquidity and sovereign debt crisis iceberg that could destabilize European banks (and the entire money market system here in the U.S.).
Whatever the tipping point, a healthy dose of fear, not panic, finally set in. Global equity markets trimmed about 210 basis points during May and almost another 160 basis points in June. The rising yields in the bond market gave way to a classic flight to safety, and Treasury yields fell soundly to around 3.0% in the latter part of the quarter. Our view is that this correction, while painful, is likely not over, with equity markets around the planet trading well above their fair value. As always, the path, speed, and timing of the movement to fair value is unknowable, but whether it's a pin-prick event or a slow grind, we believe a "hunker down" mentality is prudent when it comes to portfolio positioning.
There is, of course, no law that forbids expensive asset classes from becoming more expensive. There are no chiseled tablets forbidding historically low bond yields from going lower. And some bold and courageous investors may want to stay for additional courses. Wall Street is more than willing to provide the investment rationale for such a decision, and CNBC can no doubt line up a healthy roster of yea-sayers to serve up the next dish. But we have other plans. We remain defensive. We remain cautious. We are cognizant that, while valuations are not nearly as stretched as we saw in the summer of 2007, they dance dangerously close. That while the high yield market – one of the many canaries in the coal mine – is signaling all sorts of speculative froth (from historically low spreads and all manner of dodgy conditions), it is not as bad as it was only four years ago.
Faint praise indeed. And let's not get started again on Treasuries and their negative yields. No, there are still plenty of investors willing to stay at the speculative feast, but we have pushed ourselves away from the table. Our broad strategies are: Emphasize Quality stocks.
While "one month doth not a trend make," May's substantial market pull-back was illustrative of what we expect to be a string of market movements over the coming year. The market witnessed a wake-up call, if you will, to the worrisome sets of crises globally. The laundry list of worries – the looming end of QE2 most notably – has been known for some time, yet the urgency of them somehow spooked the markets starting in May. With that, we witnessed a sizable rotation into Quality. Our Quality Strategy outperformed the S&P 500 by over 330 basis points, as the appeal of highly profitable and stable, unlevered business models suddenly trumped "animal spirits." We don't believe this rotation is anywhere near complete. Nor do we believe that the list of worries is by any means "checked off." Far from it. Therefore, we happily maintain our Quality bias.
Maintain exposure to emerging markets, but with some precise hedging. We remain overweight emerging markets within global equity mandates as they represent a sub-asset class priced to deliver very decent returns. However, the China real estate bubble remains on our watch list, and, where appropriate, we have taken pains to surgically hedge specific areas of the global market that are highly tied to continued growth in Chinese real estate. Specifically, we have hedged direct exposure – Chinese real estate developers and banks – but we have crafted a custom basket of secondary and tertiary plays on the China bubble days coming to an end (e.g., Australian copper miners and luxury goods manufacturers). Either way, our position remains constructive on the broad universe of emerging equities, but with some serious caveats regarding China.
ï® Bonds back into very, very expensive territory. The rally in bonds this quarter can be called many things: a flight to safety, a deflation play, etc. We call it the way we see it: already expensive bonds just became more expensive. Our sober forecast for bonds is global in nature, just from a pure valuation perspective. Throw in a good dose of sovereign credit worries and the end of QE2, and you have a whole basket of excuses to, where possible, avoid bonds.
ï® Maintain positions in low duration fixed income and cash/cash "plus" in balanced portfolios. Truth be told, we don't necessarily like holding these low-duration cash instruments given their low yields. Their appeal, then, is not so much that they're going to make us a ton of money, but rather that they can act as "dry powder" that we can deploy when expensive assets elsewhere (read: "stocks" and "bonds") get closer to fair value. Yes, these holding are a short-term drag on performance, but the "option" they provide – to put cash to work at better pricing – gives us some degree of comfort.
ï® Invest in conservative absolute return strategies, where available. Ideally, absolute return strategies are often a pure play on manager skill. Therefore, the return streams should have little correlation to the movements of the markets. Such investment instruments can provide equity-like returns, while helping to diversify other parts of one's portfolio.
