Jeremy Grantham’s most recent quarterly report was released yesterday. Grantham expanded on his low-growth macro view with a number of additional insights based on both secular and political trends dominating the US economic picture. As usual, Grantham’s views have received a wide hearing in the media because of his track record as an investment manager. I am going to add in my thoughts here in this post.
I should begin this by saying that my own macro view, as I have espoused it here at Credit Writedowns, is also that we are in low growth mode, in particular because of an overhang of large levels of private debt. And this is irrespective of the demographic trends of an aging society already gripping countries like Japan, Germany and Italy. My view is that private debt in the US will detract from economic growth in three principal ways. First, the debt will make the US more susceptible to short business cycles by inducing greater macro volatility when the economy hits stall speed. Mid-cycle relapses have a greater chance of becoming recessions as a result, making business cycles shorter on average. Second, private debt levels will also increase the severity of recessions by adding a credit decelerator as more private agents deleverage to deal with the financial stress associated with high debt during a recession. And third, attenuating the strains of private debt-induced low growth through the socialisation of losses via public leveraging and deficit spending is politically unsustainable. The US has been an outlier in maintaining high deficits without significant levels of tax increases and/or spending cuts. I do not believe this can continue indefinitely.
Now to Grantham’s view.
In his last quarterly letter in November 2012, he wrote that he expects longer-term real GDP growth in the United States to decline from its customary 3% to 1.4% for a variety of secular causes. Many of these are the usual suspects: aging, rising resource costs and climate change. Some are more interesting. For example, Grantham wrote that manufacturing productivity is and will remain high but that services productivity is “low and declining”. Since we are switching away from manufacturing, that lowers productivity.
In this letter, Grantham turns to “Investing in a Low-Growth World” and this is the interesting bit. Grantham writes:
I believe theory and practice strongly indicate that lower GDP growth does not directly affect stock returns or corporate profitability.
[…]
For there to be a stable equilibrium, assets, including entire corporations in the stock market, must sell at replacement cost. If they were to sell below that, no one would invest and instead would merely buy assets in the marketplace cheaper than they could build themselves until shortages developed and prices rose, eventually back to replacement cost, at which price a corporation would make a fair return on a new investment, etc.
That’s the statement to describe the entire post: lower GDP growth does not affect stock returns. Grantham then shows a graph which demonstrates that in country after country over the last thirty years there is no positive correlation between real GDP growth and real market returns. (In fact, if anything there appears to be a slightly negative correlation using the regression line on his graph. But that comes with a regression R-squared of .06, which basically means the scatterplot of correlation is all over the map – no correlation).
The interesting bit is that the next exhibit in his piece shows that earnings growth is actually negatively correlated with real GDP growth – and this with a higher R-squared of .20.
Grantham finishes up by talking a bit about easy money and other distortions that are going to impact investment returns. Overall, Grantham says the investment implications here are that easy money has led to overpriced assets everywhere. But, because missing a bull market is a dissmissible offense, Grantham reckons that easy money will work for another round or two before the policy’s negative implications come to a head.
My view: I agree with Grantham’s macro framing here. And I also agree that trying to call the top is a fool’s errand. As I wrote last month on Apple: “You may see a trend early and think the stock is a sell but the reality is momentum can carry a stock higher for a long time after that; and you would have missed a huge rally. When a high-flier moves up, the peak is often a parabolic move where most of the price gains come.” From a secular viewpoint, it’s really much more about price-earnings ratio expansions and contractions than economic growth. GDP growth in the US during the secular bear market of 1966-1982 was not really appreciably worse than the GDP growth in the secular bull phase from 1982-2000. The big difference was price to earnings ratios underpinned by a nice phase of private leveraging.
From a cyclical perspective, releveraging and multiple expansion can still occur in a period that is fundamentally marked by deleveraging and multiple contraction. If the economy is expanding, the government is adding net financial assets via deficit spending, and the Fed is goosing markets via low rates and quantitative easing, that has to be bullish. It’s when those factors start working against you that you have to worry about the market falling. And when the market does fall in a bear market, the secular trend toward lower multiples exacerbates that fall.
Source: GMO [registration required]