Grantham’s Cautious Outlook
Jeremy Grantham is one of the current asset allocation gurus on Wall Street. He was co-founder of Batterymarch Financial Management in 1969 prior to founding his current firm, GMO. Mr. Grantham has been featured in Forbes, Barron’s and Business Week and is routinely quoted by the financial press. He earned his undergraduate degree from the University of Sheffield (U.K.) and an M.B.A. from Harvard Business School.
Jeremy Grantham projects 10 flat and volatile years for stocks from the average of 10 previous bubble bursts.
As one can see, the historic precedent for the equity market over the next decade would not thrill most investors. Grantham, for his part, has a few areas in which he sees the potential for returns (or at least the avoidance of losses). He calls for a normal weighting to the global equity markets, but one should steer clear of low quality domestic stocks. Larger companies with sustainable cash flows and solid business models will be able to deliver higher returns over the next seven years than their riskier small cap counterparts. In fact, Grantham calls for a negative real return for small capitalization stocks.
Safety, as it turns out, serves as Grantham’s primary theme. He recommends investors “tilt” their portfolios toward safer assets wherever possible. For instance, with interest rates at a record low, Grantham suggests avoiding duration risk in bonds. The price of bonds move inversely with interest rates; so if interest rates fall, the bond is worth more and vice versa. When, not if, interest rates rise, bondholders with more duration (interest rate sensitivity) will suffer more than those whose bonds have shorter duration. His firm’s seven year asset class forecast predicts most fixed income asset classes will also have negative real returns, with Emerging Market Debt as the exception returning a modest real 1.3%. Grantham also stresses that investors should not be too proud to hold “substantial” cash reserves over the foreseeable future. Finally, Grantham is a firm believer in limited natural resources on the planet. In the past, he has eloquently defended the Malthusian argument that exponential population growth and economic development will strain many, if not all, of Earth’s natural reserves. Subsequently, as an investor, he has taken interest in commodities as well as companies that help bring them to market. Grantham recognizes that volatility in commodities makes it difficult for many investors, therefore, he is constructive over the long-term (10 years) on many natural resources. He does admit, however, that there is a coin flip’s chance that the current global slowdown and normalized weather patterns may provide a lower entry point for investors. That is, commodities very well may see price declines in the short-term.
Don’t Fight the Fed
While Grantham has a less than rosy outlook over the next seven to ten years, numerous factors such as fiscal policy, a global economic slowdown, a trade war, unexpected new technologies and industries or a multitude of other factors could dramatically change the forecast. Perhaps the most influential factor for the United States is the Federal Reserve’s monetary policy. Certainly over the past few years, the Fed has had a profound influence on markets as the chart from Doug Short (dshort.com) below illustrates.
Source: Bloomberg Professional
The graph displays that while fiscal policy (PDCF, TALF, TARP, etc.) was not immediately effective in the markets, the Fed’s zero interest rate policy as well as quantitative easing (QEs) had an enormous influence. The S&P 500 rallied significantly during both QE periods in which the Fed injected more money into the economy, exhibiting investors’ drive for more risky assets. On the other hand, at the end of each easing period, the stock market fell as investors became more risk averse.
The key question becomes what will be the Fed’s policy going forward. The central bank has already declared its intention to keep their benchmark interest rate near zero through at least 2013. As the economy stumbles again with threats of a credit crisis in Europe, would the Fed undergo more quantitative easing programs, and would it have the same effect of driving investors into riskier assets? The consensus remains that while further monetary stimulus may occur in the near term, over the intermediate term the Fed will significantly reduce its balance sheet, which has ballooned over three times since 2007. Whatever happens over the next few years with monetary policy, investors should remember the old maxim: “Don’t Fight the Fed!”
Implications for Asset Allocation
The common thread between Grantham, central bank policy, and market analysts as a whole is that volatility and lower real returns from traditional assets will be around for the next few years at a minimum. Thus, it is important for institutions to examine their return expectations and ways to meet their required investment returns.
Most institutional investors such as endowments, foundations, and pension plans, have an investment goal of 5% over the rate of inflation. This is in line with the actuarial interest rate assumption of most pension plans which averages 7.5% to 8.0% nationwide, and accomplishes the most common spending policy of endowments and foundations, which is 5%, plus keeping the principal indexed to inflation.
Asset allocation has always been one of the most important decisions investors make, and with the volatility and uncertainty of the current environment, it is one of the most difficult. Studies indicate that the asset allocation decision accounts for a majority of an investor’s experience in both risk and return. Most sophisticated investors have an asset allocation policy including a target allocation for each asset class, and an allowable range collared around each target. This is known as Strategic or Static Asset Allocation. Over long periods of time Strategic Asset Allocation has accomplished the goals of most investors. However, long term is more than 25 years! In the shorter term the investment goals have been difficult to achieve with only a Strategic Asset Allocation system, and the traditional 60% equity / 40% fixed income indexed strategy has failed to meet the goal.
The Importance of Asset Allocation
The chart below displays various asset class returns over the past 15 years. As one can see, returns vary greatly year to year. For instance, look at emerging market equities. In 2007, the index returned nearly 40%. The next year, however, it fell over 53% and in 2009 it rose 79% (though still below its level at the end of 2007). With that much volatility, many investors lost faith in the emerging market asset class at the wrong time and missed the subsequent rally in 2009. In fact, a recent study by J.P. Morgan Asset Management found that stocks and bonds both returned 7.7% and 6.1% respectively over the last 20 years. There is no combination of stocks and bonds over this period that would earn the required 8% return of most pensions, foundations and endowments. J.P. Morgan also found that an average investor returned a mere 2.6% over this period. Clearly, investors buy and sell assets at less than ideal times.
Past performance is no guarantee of future results. This graphic is for illustrative purposes only and not indicative of any specific investment. An investment cannot be made directly in an index.
Active Asset Allocation
So what steps can institutional investors take to meet their return requirements? For decades, a blend of stocks and bonds, traditional assets, appeared to be the answer. Over the past fifteen years, however, the mix of 60% stocks and 40% bonds has not met the common benchmark of inflation plus 5% for spending. The next step involved diversifying into new asset classes. These asset classes may have included foreign securities, real estate, commodities and master limited partnerships (MLPs). By doing so, investors could beat the inflation plus 5% benchmark, albeit by taking on slightly more risk. As illustrated in the asset class table above, many of the new asset classes added had more volatility and during times of market stress like 2008, they did not offer the correlation benefits investors had previously expected.
The final step to a stronger asset allocation, which should be beneficial with the expected market turbulence over the next few years, is to add a level of dynamic risk management. Equitas’ dynamic risk management tool aims to identify asset classes that exhibit either positive or negative intermediate trend on a monthly basis. In other words, invest in asset classes that appear to be going up for the next month and do not invest in those that appear to be going down.
While the dynamic risk management tool may be extremely helpful in identifying investments, it does not complete the active asset allocation process. In order to build a more efficient portfolio, assets should be rebalanced from the negative (non-invested) to the positive asset classes. A hypothetical back-test of this approach shows that Active Asset Allocation both lowers risk and increases return historically.
In 2002, Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC, located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high-net-worth family offices.