Jermeny Grantham's GMO has released its second quarter letter to its partners. The letter is broken up into two parts, one written by Grantham titled, "Ten Quick Topics To Ruin Your Summer," and the other, "Price-Insensitive Sellers," by Ben Inker.
GMO's second quarter letter
Price-insensitive sellers
The last decade has seen an extraordinary rise in the importance of a unique class of investor. Generally referred to as “price-insensitive buyers,” these are asset owners for whom the expected returns of the assets they buy are not a primary consideration in their purchase decisions. Such buyers have been the explanation behind a whole series of market price movements that otherwise have not seemed to make sense in a historical context. In today’s world, where prices of all sorts of assets are trading far above historical norms, it is worth recognizing that investors prepared to buy assets without regard to the prices of those assets may also find themselves in a position to sell those assets without regard to price as well.
This potential is compounded by the reduction in liquidity in markets around the world, which has been driven by tighter regulation of financial institutions and, paradoxically, a greater desire for liquidity on the part of market participants. Making matters worse, in order to see massive changes in the price of a security, you don’t need the price-insensitive buyer to become a seller. You merely need him to cease being the marginal buyer. If price-insensitive buyers actually become price-insensitive sellers, it becomes possible that price falls could take asset prices significantly below historical norms. This is not to suggest that such an event is inevitable, still less is it an attempt to predict in which assets and when it will occur, but anyone conditioned to think that these investors provide a permanent support for the markets should be aware that the support may at some point be taken away.
Who are these guys?
There are a number of different groups of investors that could be characterized as price-insensitive buyers. A less than exhaustive list would include the monetary authorities of emerging countries, developed market central banks, defined benefit pension plans (particularly in Europe), insurance companies, risk parity investors and single-strategy and index-driven mutual fund managers.
Monetary authorities
The first group of price-insensitive buyers to confound the markets were, arguably, the monetary authorities of emerging countries, who in the 2000s began to accumulate a vast hoard of foreign exchange reserves. These reserves, which served to both protect against a recurrence of the 1997-98 currency crises and encourage export growth by holding down their exchange rates, needed to be invested. The lion’s share of the reserves went into U.S. treasuries and mortgage-backed securities, causing Alan Greenspan and Ben Bernanke to muse about the conundrum of bond yields failing to rise as the Federal Reserve lifted short-term interest rates in the middle of the decade. I have to admit that from a return standpoint, those purchases were ultimately vindicated by the even lower bond yields that have prevailed since the financial crisis. But just because the position turned out to be a surprisingly good one, returnwise, doesn’t mean that these central banks were acting like normal investors. Their accumulation of U.S. dollars had nothing to do with a desire to invest in the U.S., in treasuries or anything else, but was rather an attempt to hold down their own currencies. This made them more avid buyers as U.S. interest rates fell, insofar as falling U.S. rates tend to push down the U.S. dollar. The aggregate impact on markets from these price-insensitive buyers has almost certainly been considerable, as can be seen in Exhibit 1. Since 2000, some $6 trillion of currency reserves have had to be invested, and most of that has gone into high quality U.S. fixed income.
Did emerging market currency reserves cause the risk bubble in 2007? It would be hard to lay that at their feet given all of the stupid behavior by a whole variety of market participants, but it is certainly easy to imagine that by both taking high quality assets out of circulation and pushing down yields as they invested a net $3 trillion from 2003 to 2008, they could have pushed demand into the riskier assets that got so mispriced in 2006 to 2008.
After a small blip in 2008, these reserves continued to power higher through 2014. So how do these buyers turn into sellers? Easily. It has already been happening, actually, as commodity-producing countries have been selling down currency reserves to support their domestic economies. The dragon in the room is China, where official reserves have gone from $150 billion in 2000 to $3.8 trillion today, a 25-fold increase that has left it with reserves greater than the next six largest national reserve holders combined. China has seen its official reserves fall by about $260 billion from their peak in mid 2014, as a weakening domestic economy seems to have reversed the pressures that led to their accumulation of reserves in the first place. The impact of these sales has been hard to see, probably due to the second group of price-insensitive buyers.
Developed market central banks
The financial crisis itself created the second group of price-insensitive buyers, developed market central banks. Quantitative easing policies by a wide array of central banks have had the explicit goal of pushing down interest rates and pushing up other asset prices. While one can argue that the central banks were anything but price-insensitive in that they cared quite deeply about the prices of the assets they were buying, they certainly were not buying assets for the returns they delivered to themselves as holders, and their buying has been driven by an attempt to help the real economy, not an attempt to earn a return on assets. Since 2008, the sum of the U.S., U.K., Eurozone and Japanese central banks have expanded their balance sheets by over $4 trillion USD, as shown in Exhibit 2.
At the moment, the most active central banks in the developed world have been the European Central Bank and Bank of Japan, who between them are buying north of $100 billion a month of government bonds.
Defined benefit pension plans
Considerations of profit and loss on their portfolios are seldom on the minds of central bankers, making them obvious candidates as price-insensitive buyers. But regulatory pressure can push otherwise profit-focused entities in similar directions. Successive tightening of the regulatory screws on defined benefit pension funds, particularly in Europe, has forced many of them into the role of price-insensitive buyers of certain assets as well. Some of the first to push down that path were U.K. plans, where mandatory cost-of-living adjustments to pensions made U.K. inflation-indexed bonds a required holding, even as rates moved into hitherto unthinkable negative real rates. These were soon followed by other European funds such as the Dutch, where the Dutch central bank forced the plans into owning very large portfolios of liability-matching assets, largely high quality long-term bonds. It’s not that it is silly for investors to consider the nature of their liabilities in building their asset portfolios, and it also makes perfect sense for regulators to step in when there is the kind of agency problem that exists for defined benefit pension plans.1 The trouble is that in order to prevent the sponsors from doing inappropriately risky things, gray areas and matters of valuation are generally dealt with poorly, if at all. As an example, inflation-linked bonds are certainly a low-risk asset against an inflation-linked liability of a similar duration. But real estate, infrastructure and equities are also long-duration inflation-linked assets. While their cash flows are less certain than a government bond, the relative yields available on these assets would be a crucial consideration for a rational asset allocation. In the U.K., however, regulations declare that the index-linked bond is an inflation hedge in a way that others are not, and the regulations require hedging the portfolio. The real yield on long-term inflation-indexed bonds in the U.K. has been close to zero or negative for most of the last decade, yielding far less than other assets that can be plausibly thought of as inflation hedges. The funny thing about the regulatory pressure is that it pushed hardest on the long-term inflation-linked bonds due to the long-term nature of the pension liability. The U.K. issues a 50-year inflation-linked bond. The bond maturing in 2062 yields -0.8% as of July 3. But it references RPI as its inflation adjustment, and this tends to be 0.5 to 1.0% higher than CPI, so let’s assume this is equivalent to 0% over inflation. An investor interested in earning returns between now and 2062 can lock in a guaranteed zero return instead of the uncertain return from assets like stocks and real estate. So what are the odds that stocks do worse than 0% real over the next 47 years? Exhibit 3 shows the likelihood of stocks underperforming an asset guaranteeing a 0% return as a function of time horizon. It shows both the probabilities if stocks return +5.7% real with a volatility of 16% and do not mean revert and the probabilities given the actual historical returns of stocks in the U.S. since 1871.
In a world of no mean reversion, there is indeed a chance of stocks underperforming the 2062 index-linked bond over the course of its life – approximately a 1% chance. For what it’s worth, the average shortfall relative to 0% real for that 1% of the time is 24%. And this means that if you are actually interested in wealth in 47 years, you can either guarantee to maintain your wealth exactly by owning the index-linked Gilt, or invest in stocks and have a 99% chance of doing better than 0%, with an average terminal wealth of 13.5x your initial amount. In the unlikely event that you are in the 1% that falls short, you would expect to have lost 24% of your initial amount. If the odds were even on that trade – a 50% chance of making 13.5x your money and a 50% chance of losing 24% – you should take that trade all day long. With 99% odds of winning, it seems you’d have to be insane not to.
And yet, in the last decade, managers of U.K. pension funds have basically doubled the percent of their portfolio that they had put into long-term index-linked Gilts while cutting their allocation to equities by a similar amount. And they are not insane. They are doing what they are forced to do by a well-intended regulatory framework. And the point to recognize about their willingness to buy the index-linked Gilts and sell equities, given the pricing, is that managers choosing to buy the bond in that situation are clearly unlikely to change their buying decisions based on a change in the yield on the bond. It is not as if they bought them saying “at zero real I’m a buyer of the bonds, but -0.5% real would make me a seller.” So if yield won’t do it, what else could? Actually, the answer is very simple and leads to our concern about the index-linked Gilt market. If a class of investor is forced to buy a type of security irrespective of price, the thing that can change that behavior is the cash flow of that class of investor. When cash is flowing into U.K.-defined benefit pensions, the marginal buyers of index-linked Gilts are almost certainly those pensions. When cash begins to flow out, they basically cannot be buyers of the index-linked Gilts anymore and could easily become sellers.3 The next set of buyers is less likely to be as price-insensitive as the pension funds. While bonds are finite life instruments, a 2062 bond will be around for a long time, and it is a truly mystifying investment for anyone who is not forced to own it.
