Grantham: Deflation's Coming, Hide in Quality Stocks and Avoid Bonds
Jeremy Grantham has long warned that the economy and financial markets are treacherous places to try to make a buck, and that message comes through clearly in his latest quarterly newsletter. Grantham, chief investment strategist for the fund manager GMO, anticipates deflation and continued sluggishness for the economy and schizophrenia for the markets, but he also finds opportunities for sound long-term returns in certain unloved asset classes.
"I, for one, am more or less willing to throw in the towel on behalf of Inflation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points," Grantham writes. "Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. . . . I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout. But now, better late than never, I am willing to take sides: With weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or flat prices are the prospect for the immediate future."
What tips the scales toward deflation is the belated interest in fiscal prudence and deficit cutting across Europe. As Grantham puts it, European countries "are coming on more like Hoover than Keynes." The massive fiscal and monetary stimulus last year was pure Keynesian economics, but it set the stage for the investment schizophrenia that Grantham observes. Persistently low interest rates, combined with an economy that's having trouble getting off the floor, have created what he calls "a fearful, speculative market":
"The key point here is that the economy responds reluctantly to low rates - there are so many other negative factors it has to worry about - whereas the market responds with much more persistent enthusiasm. In such a world, aggressive hedge funds . . . can leverage easily and, in their drive to make money, will emphasize more aggressive or more speculative investments."
For Mom and Pop investors, a market environment like that in an economy like this can be too hot to handle.
"Low rates, although they tend to produce a feeding frenzy at the aggressive end of institutional investors, merely produce a feeling in ordinary individual investors somewhere between dejection and desperation," he explains. "They hate to park money in cash at negative real returns, and yet they are still thoroughly nervous, so surveys reveal, about normal equity investing. These investors did not need the recent slowing in growth and sovereign debt problems to become nervous."
Grantham doesn't express the same concern about market bubbles that he did in his previous newsletter. But the investment recommendations that he and his GMO colleagues make indicate a mindfulness that bubbles may be forming in speculative asset classes like smaller-company stocks, as well as presumed havens like government bonds.
Looking out over the next seven years, they expect returns to be flat on Treasury debt and slightly negative on government bonds in mature foreign countries. The best bond returns will be a meager 2.2 percent a year in emerging markets, they predict. They foresee similar mediocrity for U.S. stocks - annual returns of 2.9 percent for large companies and 1.1 percent for smaller ones.
The outlook is better, in their view, for emerging markets and especially for shares of high-quality American companies, themes that Grantham has pushed for a while. Strong businesses should excel relative to others in a shaky economic and financial environment and therefore their stocks should trade at a premium, yet they are cheaper, he said, and have been for years.
Between their low valuations and superior prospects, Grantham says, the high-quality components of the Standard & Poor's 500-stock index should outperform the rest of the index by 6.2 percentage points a year.
As for why high-quality stocks are so cheap, Grantham speculates that they are too boring for speculators. They seem just right for ultra-safe investors, but many of them are retiring and may be inclined to cut them loose from their portfolios for income. That leaves few natural buyers.
Whatever the reason, Grantham stresses that being able to spot a bargain is more important than explaining why it has become one. "Although it is interesting to wonder why certain stocks or groups become cheap, there are no points for getting the reasons right," he says. "There are only points for knowing what actually is cheap and owning it."
