Grantham: go with high quality and hedge against inflation
Jeremy Grantham is out with his quarterly update. And he has a number of investment themes worth mentioning. First, I should mention that his global outlook is fairly downbeat:
We are experiencing the most severe synchronized global downturn in several generations. While governments have been quick to react, there are limits to what policy can do beyond blunting some of the edge of a massive consumer deleveraging cycle in the U.S. and elsewhere. Of course, times of trouble can often be profitable times to invest when they are reflected in depressed prices. And the valuation levels of equities suggest that forward return prospects are indeed much improved. This analysis is best tempered with a realization that financial results are slow to reflect the new economic reality, and that many superficially cheap stocks may fast start to look expensive as their financial position deteriorates. In that light, the Japanese market looks attractive, since it seems unlikely that the next 10 years will be fundamentally worse than the last 10, whereas in the U.S. or Europe that seems quite possible, if not probable.
Emphasis added. I think this view is in line with my “Fake Recovery” meme which basically says we are seeing a stimulus induced cyclical upturn but that will not presage renewed economic vigor until structural issues are dealt with. Whether or not we are in a new bull market (I tend to see this as a bear market rally), there are still many opportunities to pick up quality assets selling at depressed valuations. In line with my thinking, I have repeated Grantham’s broad investment themes below. They are moderately, but not overly bullish, with a preference for high quality over low quality and protection against inflation. You should note that Richard Bernstein, the now departed strategist at Merrill Lynch had recently outlined similar strategies.
Our broad strategies are:
- Emphasize more defensive fixed income and high quality U.S. equities. Having rallied into the teeth of the crisis as the only liquid safe haven asset, sovereign
bonds now look dangerously over valued. Unless deflation is deep, prolonged, and persistent, government bond investors are likely to be very disappointed in the medium term. In addition, it is very possible that the size of new issuance will likely further undermine current pricing.
- Adopt a bias toward high quality stocks. Value stocks are no longer a “value” and remain expensive relative to growth stocks and the market. High quality stocks trade at a slight premium to the market when historically they have traded at a much wider 18% premium to the market. While the profit margins of financial stocks have evaporated, the profit margins for other sectors are now poised to get much weaker. Quality has outperformed so far this year as financial companies have borne the brunt of the current turmoil. We believe quality will fare significantly better in the event of a worsening economic outlook.
- Prefer real yields in inflation protected bonds. Real yields are no longer as attractive after the flight to quality and liquidity episode of last quarter. Nevertheless, inflation protected securities are to be preferred to their nominal cousins. Although short-term inflationary pressure is muted, the likelihood of increasing inflation in the future has been facilitated by substantial monetary easing and quantitative easing policies.
- Continue reducing underweight to equities. Valuations are beginning to look attractive in some equity markets. In particular, international developed and emerging equities are once again offering appealing expected returns. These higher expected returns, however, are due entirely to falling prices and certainly
not due to improving fundamentals. As a result, our enthusiasm remains somewhat tempered by an uncertain outlook for profitability. Despite these reservations, we believe it is prudent to start reallocating to these sectors while reducing our overall equity underweight.
- Overweight more conservative fixed income and cash/cash “plus” in balanced portfolios. It is difficult owning fixed income at the current low yields, but we believe it is much less volatile than equities. Consequently, we have overweighted cash/cash “plus” strategies in our balanced portfolios and even owned some cash/cash “plus” strategies in some of our global accounts where permitted. We do not own cash “plus” strategies lightly, and it is the first time in almost 20 years of managing asset allocation portfolios that we have allocated a significant portion to cash. However, as we begin shifting back toward equities, we will reduce cash “plus” strategies commensurately.
- Where possible, invest in conservative absolute return strategies, which can provide equity-like returns while improving diversification through low correlations with equity markets. Try to ensure that alternative strategies are providing true diversification with low correlation to traditional asset classes.
You should definitely have a look at the complete document at the GMO website. It has much more detail and is available for free to registered users.
Update 8 May 2009: As the accompanying letter to investors is available all over the web now, I am posting here for your viewing pleasure as well. This is a good supplement to the outlook. Enjoy.
GMO Quarterly Update – Grantham, Mayerloo and Otto website