Hi!,
August sure has been a tumultuous month, with the daily changes in the Dow Jones Industrial Average over one memorable week in early August (-635,+430,-520,-424 which amounts to daily movement of +/-4.5% in the largest and most liquid stock market in the world!) resembling more of a random walk than rational responses to changes in fundamentals. Volatile markets are likely to be with us for a while – as long as government policy uncertainty remains with us in the developed world. With this uncertain backdrop, I summarise below Jeremy Grantham’s latest quarterly which provides ( as usual) deep insights into the current state of markets and his outlook.
-“Can-kicking” to postponing the day of reckoning is an art form perfected by countries around the world – from Britain’s peace agreement with Hitler in 1938 to modern day examples of Japan’s lost decades , Europe over the last 10 years (by failing to rein in the growing uncompetitiveness of the peripheral countries) and finally to the US’s refusal to deal with the housing bubble earlier.
-His prediction in early 2009 of “seven lean years” for the US economy was somewhat optimistic - while some factors have shown modest improvement other key factors have failed to keep up with what were pessimistic expectations. GDP would have to grow by 4% a year for the next 3.5 years (unrealistic) to close the gap with the 2% projected trend line growth rate of the economy.
-The plus side of the “seven lean years” have been: the resilience of emerging economies, particularly China and India; the sizes of the Chinese trade surplus and US trade deficit have declined; the US savings rate has increased from 1% to 5%, and, corporate profits have risen.
-The negative side of the “seven lean years” is a long list: disillusionment with institutions and capitalism has increased, dampening animal spirits; resources prices are even higher than expected; fiscal deficits are higher ; housing prices are lower and could overshoot more on the downside; personal income growth has been very meagre with gains accruing to corporations and the very rich making the US one of the least egalitarian developed societies; while private debt is declining modestly through write-downs and pay-downs of debt, there is no new debt being created to boost consumption which remains anaemic; economic policy remains caught between half-hearted Keynesian stimulus and ill-timed “Austrian” cutbacks; if unchecked the “seven lean years” could rapidly result in a dramatic loss of the US’s leadership position, which has been a show piece to the world of entrepreneurial drive, effective government, social leadership and international justice and assistance.
-Corporate profits are at their highest levels, while wage growth is flat and 16-18%of workforce is either out of a job (9%) , discouraged to look for a job (4%) or working part-time (5%). Normally these conditions would have led to lower revenue growth, but the surge in government debt has allowed corporations to maintain top line growth while reducing costs and thereby increasing profits. This likely to change as government debt falls or its growth decelerates.
-In the current environment which is fraught with uncertainty , as he advised last quarter, its best to be cautious and remain cautious for the foreseeable future. Quality stocks have continued to outperform low quality stocks and points towards a classic late bull market rally.
-He continues to favour the following asset classes:
-Well-managed forestry and farmland.
-Natural resources, energy, metals and fertilizers over the next 10 years though near term they could be experience sharp declines.
-Quality stocks are priced to provide 4.5-5% real return.
-Emerging market stocks are also likely to provide 4-5% real return.
-Japanese stocks have the potential to provide double digit real returns for the next 7 years.
-Other global equity markets range from unattractive to very unattractive. With the S&P fair value being 950.
-Cash will provide the dry powder to take advantage of possibilities.
-Stop press: with the sharp market declines in early August, they became modest buyers for the first time since mid-2009 and own US high quality stocks, emerging markets, Japan, Italy and European growth stocks, with this portfolio likely to return about 6.5% real over the next 7 years.
-The main long-term risk continues to be that, after two massive bubbles and reflation programmes, the Fed may be out of ammunition if a serious global double-dip ensues.
-This would imply that instead of a sharp recovery in markets, they could become cheap and stay below long-term averages for a long while as has been the norm historically (pre-Greenspan). This would wash away a whole generation’s false expectations, high animal spirits and excessive risk taking. It would also mean high long-term returns from investing at cheap levels – i.e. long-term gain from short-term pain!
A brilliant piece which succinctly lays out the risks as well as the opportunities which the markets face today. A core equity funds portfolio in US quality stocks, global energy and natural resources, select emerging markets (China, India, Brazil, Russia), Japan, Korea, Singapore combined with a core bond funds portfolio (EM and select developed world govt& high grade credits denominated in local currencies, US private mortgages and credits) and a core portion in cash diversified across several currencies, and finally, gold, should be able to weather the storm ahead and provide decent returns over a 3 -5 year period. The key is to be disciplined in terms of not giving way to temptation to time the market, or be swayed by market movements, which inevitably is a recipe for buying high and selling low over time.
For those who doubt the positive impact of QE programmes on the markets and the economy i attached a graph which rather vividly demonstrates the relationship between the commencement and ending of the QE1&2 programmes and the waxing and waning of economic output. Yes, the effect is only temporary (and is not claimed to be otherwise) and can have unintended consequences (higher commodity prices) but it does work – as the economist Irving Fisher noted long ago in his classic study of deflations and depressions in the 19th and early 20th centuries. So if the economy continues to sputter along, or goes into another dip, we are likely to get another dose of QE (later this year?) and further fiscal stimulus (early next year?) as well which will limit the downside and provide potential for upside.
A health tip:
I came across a particularly interesting story on how daily mild exercise can add to your life expectancy:
Exercising for 15 minutes a day adds three years to a person’s life expectancy, according to the first study to show there’s a health benefit from even low levels of physical activity. In a study involving more than 400,000 people, those who exercised for 90 minutes a week were also 14 percent less likely to have died after eight years than those who were inactive, researchers at Taiwan’s National Health Research Institutes wrote in The Lancet medical journal. Every extra 15 minutes of exercise reduced the risk by a further 4 percent., up to 100 minutes a day, after which there was no additional benefit.
So get on with the daily walk/swim/yoga – it’s not that complicated!
I will be travelling (again!) over next weekend so the next newsletter will be sent on September 10.
Regards,
Aditya
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