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Holly LaFon
Holly LaFon
Articles (9489)  | Author's Website |

Ben Inker's GMO 4th Quarter Letter: And the Winner Was … T-Bills?

A down year makes for much-improved opportunities

February 13, 2019 | About:

Executive Summary

2018 was a lousy year for almost all assets, with no major asset class around the world able to keep pace with U.S. Treasury Bills. The poor returns were not driven by any economic calamity, but by markets coming into the year with unrealistic and incompatible expectations, which wound up being generally disappointed. The poor returns have a silver lining, however, in that today a number of asset classes are priced at levels that embody much more achievable expectations and decent long-term returns. In general, it looks to be the best opportunity set we have seen since 2009. This means it is reasonably straightforward to put together a diversified portfolio priced to achieve something close to +5% real return. But as U.S. equities and nominal government bonds are not among the appealing assets, we believe the portfolio you should own today looks more or less nothing like a traditional 60% stock/40% bond portfolio.

Your portfolio likely lost money last year. It wasn’t in a catastrophic, 2008 kind of way, but I am reasonably confident in saying that for U.S. dollar based investors reading this, 2018 ended up with a negative sign before your total return. The strong U.S. dollar meant that non-U.S. investors owning unhedged foreign assets did a little better than their U.S. counterparts, but only in places like Australia and Canada, where local currencies were very weak, would many investors have had a shot at achieving positive total returns. Of the asset classes that traditionally have meaningful allocations in institutional portfolios, only the Bloomberg Barclays U.S. Aggregate Bond Index (Agg), a proxy for investment grade bonds, gave a positive return in U.S. dollars – and it earned a princely +0.01%. Otherwise, pretty much everything was down. The S&P 500 fell 4.4%, soundly trouncing both MSCI EAFE (down 13.8%) and MSCI Emerging (down 14.6%). Real estate proved no hedge, with REITs falling 4.6%, and small caps were even worse than large caps, with the Russell 2000 down 11% and MSCI EAFE Small Cap down 17.9%. Credit was no haven either, with the Bloomberg Barclays U.S. Corporate High Yield down 2.1% and the J.P. Morgan EMBI Global emerging debt index down 4.6%. The best performing major asset worldwide was stodgy old U.S. Treasury Bills, up 1.9%. It was the first time since 1994 that T-Bills beat both the S&P 500 and the Agg, and the first time since 1981 that they outperformed those assets along with non-U.S. equities, small caps, and REITs. It is worth pointing out that in 1981, T-Bills returned over 15%, so an index could trail it and still deliver a double-digit return. As a result, 2018 arguably set a new standard for universal dismalness.

For all that, a 60% stock/40% bond portfolio1 lost only 5.5% for the year, a far cry from the 26% loss such a portfolio suffered in 2008. In reality, it was merely the fifth worst year in the past 30, hardly an outlier in a total return sense. What feels so odd about 2018 was the sheer unavoidability of the losses. In 2008 you could at least daydream about having had the foresight to move your portfolio to government bonds and reap a +12.4% return. There was no such haven asset in 2018.2 Had you had perfect foresight about asset class returns for the year, the best your long-only portfolio could have achieved was +1.86%, earned by investing your entire portfolio in 3 month Treasury Bills.

The other interesting feature of the year was the fact that the broad swath of losses across asset classes was not driven by any particularly horrible economic events. According to the IMF World Economic Outlook report, real GDP growth for the 12 months ended June 2018 (the most recent data I could find) was +3.2% U.S. dollar weighted and +3.7% purchasing power parity weighted. These were the best growth rates since 2010 and 2011, respectively. World inflation, while up 0.6% from 2017 at +3.8%, was below the average level since 2000. And yet, more or less every asset capable of delivering a capital loss did so.

So, what gives? It comes down to expectations. The simple answer is that markets came into 2018 with an unrealistic set of expectations, and more or less all of them were disappointed. Bond markets assumed inflation and growth would be so muted as to dissuade the Federal Reserve from raising rates four times, as it had suggested was its plan. Stock markets assumed growth would be strong, and appear durable, driving earnings and the expectations for future earnings high enough to keep stocks competitive with the higher yields available on cash. Credit markets assumed that growth and inflation would be muted enough to keep rates low, but corporate cash flow high enough to keep default rates at cycle lows. Real estate assumed that growth would be strong enough to stimulate demand, but rates low enough to keep financing costs from rising. As it turned out, growth was too strong for the bond market’s liking, and too weak for the other asset classes. It is a clear reminder of the truth that it doesn’t take a disaster to lead markets to losses, only a disappointment. Disasters certainly aren’t very good for portfolios, but investing is far more complicated than simply avoiding risk coming into a recession.

Exhibit 1 shows the annualized performance of the S&P 500 in real terms in recessions and expansions since 1900.

Returns were certainly a bit better on average during expansions than recessions – +8.6% real versus +6.7% real. But it is abundantly clear that any narrative that says “stocks do well in expansions and poorly in recessions” is silly. Markets tend to do badly when disappointed and well when positively surprised. The onset of a recession usually comes as a disappointment. If you can predict that disappointment, you will indeed avoid some pain. But predicting a recession, as hard as it is, is not enough. You need to predict that things will be worse than the market expects. If you believe there will be a recession and the market agrees with you, there is no sense in selling your equities. Similarly, once the recession starts, its end will probably come as a positive surprise. If you wait until it is easy to see the recession is over, you may well miss out on a significant market recovery.

How Do You Predict a Surprise?

But if markets respond to surprises and surprises are difficult to predict, does that mean we have to just give up on being able to forecast anything? I’d suggest not. Rather than giving up, I think it makes sense to focus on situations where the odds of a positive surprise are better than average. When are the odds of a positive surprise better than average? When expectations are really low. Low expectations do not guarantee a good outcome, but they do allow for decent outcomes in the absence of what most investors would consider to be “good news.” To illustrate, let me ask you which country in the world actually had a positive stock market return in U.S. dollars last year?3 Let’s think a little about what type of country it might be. The best performing sectors in 2018 were utilities and health care and the worst were materials, financials, industrials, and energy. So perhaps we’d want to think of countries heavy in

more defensive sectors and lighter in cyclicals and financials. From a regional perspective, emerging markets underperformed developed markets, so we’d probably want to look at the developed world. The obvious candidates would be countries like the U.S. and possibly Switzerland. Both did outperform the average country in the year, with returns of -4.4% and -8.2%, respectively. But the winner for the year was Russia, with a return of +0.2%, despite a stock market consisting almost entirely of energy, materials, and financials; an ongoing war with one of its neighbors; significant economic sanctions; and real GDP growth of a paltry +1.4%. The best thing one could say about Russia in 2018 was that things could have been worse, and with some of the cheapest valuations in the MSCI All Country World Index (ACWI) coming into 2018, it was priced for some pretty nasty events. The second best performer was Brazil, with a loss of only 0.2%. Again, we can’t exactly claim this was a banner year for the country, with economic growth of +1.3% real, a marked absence of needed economic and political reforms, and the election of a right-wing populist lacking any particularly obvious qualifications for governing and espousing more killings by the police. But things could certainly have been worse, and slow GDP growth is certainly better than falling back into the depression that had seen the biggest fall in Brazil real GDP going back at least as far as the 1950s.

So, what are investors expecting in 2019? The good news is that expectations are not as ebullient as last year, but things differ materially across regions. Forecast earnings growth for the S&P 500 is 16%,4 which is admittedly down from over 25% a year ago. This is a little misleading, however, as much of last year’s forecast and actual earnings growth came directly from the corporate tax cut, and there is no similar windfall in the cards for next year. Growth of 16% is extremely strong by the standards of anything other than 2018, implying real growth of over 5 times the long-term history for the S&P 500. So analysts are certainly still quite optimistic about the prospects for U.S. corporations. Analysts in the rest of the world are positively gloomy, however, with growth estimates for MSCI Emerging and EAFE at 2.5% and 1.2% – approximately 0% and -1% growth after expected inflation!

  1. 60% MSCI All Country World Index/40% Bloomberg Barclays U.S. Aggregate Bond Index.
  2. I don’t have good data on the returns to private credit for the year, and it is possible that when such indices come out they will show a meaningfully positive return. If so, it will be due to the fact that the loans will not have been marked to market, as they somehow seldom are in that asset class. While that apparent stability may help explain the appeal of the asset class in recent years, equities delivered positive returns in 2018 as well, if you’ll allow me not to update prices from the levels at which they were purchased.

Read more here.

About the author:

Holly LaFon
I'm a financial journalist with a Master of Science in journalism from Medill at Northwestern University.

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