Thoughts on the latest GMO Asset class return forecast

I got GMO’s July 2017 update of Return Expectation over the next seven years. This form the basis of their asset allocation. You just need to set up a simple login to see their Asset Class Return forecasts.

The best way to read it is to compare it with their forecasts in recent months. I have compared it to May and March 2017.

U.S. large cap stocks, U.S. High Quality Stocks, International Large cap stocks, Emerging stocks and emerging debt have all become more overpriced in the last few months. Hence, GMO forecast of returns from these asset classes has become progressively lower over the months.

If we compare it to the situation in August 2016 – one year ago – Emerging market bonds and U.S. bonds have become somewhat less overvalued. That is, the return expectations from these two asset classes have improved in the last twelve months.

However, please note that the return expectations are still negative in the case of U.S. bonds. So, according to their model, it is still overvalued but somewhat less so than in August 2016.


10th anniversary awards

On the 10th anniversary of the beginning of the Global Financial Crisis of 2008 (it began in 2007), we have a few awards to give.

The top prize for market efficiency goes to the Eurozone BB rated BofA Merrill Euro High Yield index whose yield is the same as that of the U.S. Treasury index of BofA-Merrill. [Link]. See chart below.

european high yield

Second prize goes to the Bank of Japan for becoming the market all by itself – both the buyer and the seller – in Japanese stocks and thereby enhancing the working of the market mechanism itself! [Link]

Third prize goes to the Swiss National Bank for becoming the buyer of first and last resort for FAANG stocks. 20% of its Reserves are held in U.S. stocks now! [Link]. From central planning of interest rates to public sector ownership of public markets!

Fourth place should go to investors themselves – who can still teach a trick or two to these central banks.

An $800 million subprime auto bond sale from Westlake Financial Services Inc. last week was priced at some of the highest valuations — as measured by the extra yield the notes offered compared with the benchmark rate — since 2014, the analysts wrote in a note Monday. The portion of the security rated BB, or two steps below investment grade, offered the least additional yield for a deal of its size and rating on record. Demand for the offering was strong enough to increase its size from a planned $700 million. [Link]

Political risks and stocks

I just read a Gillian Tett piece (could be behind a paywall) in FT published two months ago. She felt that investors (stock markets) should heed political risks. She had referred to the probability of a Presidential impeachment suggesting that markets have not priced that in! But, to be fair to her, the article suggested other important issues and considerations.

I had posted the following comment on her article:

It is good to see some very interesting, insightful and useful comments on the article. I loved the comment by Mr. Graham Lovell from Australia. I am reading the ‘Global Economics History: A Very short Introduction’ by Professor Robert Allen. He notes that the economic model for Western nations in the 19th century and in the early part of the 20th century before the wars and the Depression intervened was: mass education, mass banking, national markets and external protection. Colonisation helped the British to source raw materials cheaply and force their finished products on colonies, decimating the colonies’ manufacturing base. De-industrialisation.

So, free trade was not the formula or route to economic growth and prosperity. It has helped many to prosper in the developing world too, no doubt, in recent decades. But, that is a very small portion of their overall population. India is an example. China benefited in the last three decades but it practiced exactly the kind of ‘free trade’ that today’s advanced nations practiced in their early development phase.

So, Trump’s model – if it can be called that – is very consistent with international empirical evidence. Now, I certainly do not think that American stock market investors had been very perceptive enough to understand this and price it in, because the stock market was not cheap by any means when he took office.

That the stock market has not been pricing in geopolitical risk is not something unexpected. One, average holding periods have shrunk to a few months. Two, stock markets (and, financial markets more broadly) have demonstrated a singular lack of ability to price in either complex or long-term risks. Since the 1980s, global debt and debt in advanced nations, in particular, has risen in absolute terms and as a percentage of GDP to today’s unsustainable levels. What did stocks and bonds do? In the last three decades or so, bond yields have been in secular decline and stocks have also move higher, in sympathy with declining yields.

So, financial markets are myopic – both with respect to the factors that they discount and their horizons.

Third, we should not forget that the Federal Reserve monetary policy is in the process of moving away from being ‘extraordinarily reckless’ to ‘somewhat extraordinarily reckless’. The European Central Bank has not stopped its ultra-loose policies nor has the Bank of Japan and nor has the Bank of England and scores of other smaller European nations. China’s liquidity splurge in the last few months that has restored economic growth to ‘respectable’ levels too must have found its way into international assets via capital outflows, at least until very recently.

So, in a sense, the stock market rise in the last few months could very much be explained by generous liquidity and ‘still irresponsible’ monetary policies in most advanced nations and not attributed to President Trump, for the most part.

There is a small role for him and his policies in the sense that investors could have ratcheted up their earnings expectations anticipating a large corporate tax cut. But, surely, they had not reduced their expectations after his failure to get health care reform through and after many of his initiatives faced legislative and judicial roadblocks.

Real economic growth indicators – notwithstanding auto sales – had perked up quite a bit in recent months. I am referring to the Chicago Fed National Activity Index (CFNAI), Durable Goods Orders and the Labour Market Conditions index of the Federal Reserve. The index of confidence among small businesses (the sentiment index published monthly by the National Federation of Independent Businesses) had shot up in November and has held there in the last few months. They are anticipating a massive de-regulation under the new administration.

Journalists and academics had paid far too little attention to the chokehold that the regulations of Obama administration had placed on the American economy. On a per day basis, the regulations passed by his administration exceeded that of Presidents Bush and Clinton before him.

So, anticipation and delivery of de-regulation have also had a role to play in the improvement in economic optimism notwithstanding complex political noise. Perhaps, certain sections of the society are sole producers and consumers of their own dissonance with respect to Trump with little heed for any objectivity.

In sum, the stock market ascent of the last few months has something to do with the changed executive focus on regulations but a lot to do with traditional irrational and myopic considerations.

Equally, if the stock markets crash -as they will, at some point – it cannot be pinned on President Trump.

Wrong message from Financial Conditions

Goldman Sachs has come up with its new revamped G-10 Financial Conditions Index (sorry, no link is possible). The biggest problem is that it is pro-cyclical. A bit like the Credit Rating Agencies whose ratings are the best when the asset valuations are the highest and hence the risk is at the highest.

If the strength in the bond market and in the stock market is very high  – lofty valuations and tight spreads (credit spreads) – then the risk of a correction and financial conditions becoming tighter is also the highest at these levels. Therefore, as asset prices keep rising, financial conditions going forward come under increasing risk.

Financial conditions are the most favourable for growth when they are extremely tight. In other words, they cannot get any worse. They can only keep getting better. That is why 2009 was the best to invest and was also heralding the recovery (no matter how tepid it was).

This is a bit counter-intuitive. But, it needs to be grasped. Mainstream institutions have not grasped them because their incentives are not aligned to grasping this truth. Their business models would collapse, if they did so, perhaps. I do not know.

Unjustified Indiaphoria

A friend sent me a message this morning on WhatsApp:

“Rupee at 63 handle, Sensex over 30k, nifty over 9300! Too good to last? Methinks not!”

My response:

“Sorry, Sir. I am afraid so. Economic fundamentals do not justify them. I will be happy to short them all, if I can.”

That response was given as someone who was the Chief Investment Officer of a Wealth Manager and one who is a natural contrarian (with all its attendant risks and pitfalls) when it comes to investing.

In other words and in the interests of brevity, I belong to the school that believes in buying when no one has a good word to say on the market and sell when everyone is a cheerleader for a market. India, more or less, belongs to the second category.

In fact, its fundamentals are not great too. Its economic growth rate is exaggerated. The current real GDP growth is close to 6% or slightly lower. I had a blog post on it yesterday. Corporate earnings are improving but gradually.  On that, this is what I heard from a stock broker six weeks ago:

Despite an improvement in the economy after the demonetisation shock, the earnings downgrade cycle has continued. In the past month, consensus Nifty EPS for FY18 has seen 6% downgrade and that for the wider BSE100 has seen 5% downgrade. Commodity sector companies have seen the highest upgrades whereas the large downgrades were concentrated in sectors such as banks, telecom, and consumer discretionary. Consensus estimates still imply doubling of profit growth (ex-PSU banks and metals) to 15% in FY18, which looks optimistic to us, given limited scope for margin expansion.

Leather industry hubs in Uttar Pradesh have recently come under a cloud. Someone should visit them and check out the fallout of the ‘Cow Protection’ movement. Hotels are beginning to feel the fallout of the alcohol ban. See this article in FT (could be behind a paywall).

Then, the government’s orders on stents are backfiring. Pharma companies are fighting back. The government order on price controls and its rediscovery of the price controls as a public policy tool is rather unfortunate. My column in MINT yesterday was largely built around this. The consequences are not so much unexpected as they are unintended.

Reliance Jio has placed the financial health of many of its competitors under a question mark and the Reserve Bank of India has warned the banks of the risk of exposure to the telecom sector. Usually, public warnings mean that the situation is no longer a risk but a reality. It has asked banks to set aside higher provisioning.

E-Commerce start-ups are seeing big erosion in valuation and investors are marking them down in their portfolios. Further, there are other stories that sap investor morale and sentiment. In general, Indian PE/VC investing is a bit like Hotel California. You can check out but cannot leave.

Overall, bank credit growth to industry is contracting. Non-performing loans are holding back credit growth and the revival of capital formation in the country. This story is not an exaggeration. The extradition order on Vijay Mallya is a sideshow. Non-banking sources of finance are picking up market share, surely. But, they cannot be accessed by smaller firms. Not surprisingly, this article mentions that the International Monetary Fund, in its latest World Economic Outlook (April 2017), does not expect a big jump in India’s investment share of GDP.

Government’s tax and black money collection drives – laudable though they are as to purpose but condemnable as to process – are unlikely to help investment sentiment.

Notwithstanding (or, because of?) the Bharatiya Janata Party (BJP)’s political successes in elections including in Delhi, there is actually economic malaise in the country.

Financial markets and asset prices are largely a sideshow, supported by an equally unjustifiable and myopic global market sentiment. That is a separate story, however.

Shareholder value maximisation

Just managed to read two white papers that James Montier had written in March. One was titled Six Impossible Things to do before breakfast’. He decided to disagree with his Chief Investment Officer, Ben Inker. My sympathies lie with James Montier. I wrote a short piece in January for MINT as to why this time might not be different as Ben Inker and Jeremy Grantham had been inclined to argue, lately. To be clear, there is no presumption that I am right (or James Montier is) and that they are wrong.

The other piece (slightly longer but not very and eminently readable, in any case) was about secular stagnation and neo-liberalism. Again, no marks for guessing where my sympathies lie. I am fully on board with James Montier. If you are reading it, do not miss footnote no. 12.

I was interested in the paper by Asker, et al that James Montier had cited. One complaint about Montier’s pieces is that the references are not fully cited. Not that one is complaining that these good pieces are being made available for free (just a registration required at and second, it is not that difficult to locate the cited works.

Asker’s piece (co-authored) is about private firms (unlisted) investing more than listed firms in the United States. Very interesting and useful empirical work. Shareholder Value Maximisation has been reinterpreted as Short-term Stock Price Manipulation, in reality and it runs counter to long-term Enterprise Value Added. Only capital investment generates long-term returns and not financial engineering.

All of these are the natural fallout of the neo-liberal agenda that has been in place since the Eighties to which the monetary policy of the Federal Reserve has contributed greatly.  Few at the expense of many and markets at the expense of society.

You can find Asker’s paper here and a presentation on the paper here.

One thought that Donald Trump would fix it, considering how effective and rousing his last campaign advt. was. But, it appears that it is all unravelling too fast. Well, that sad story is another subject for another occasion.

Why is finance pro-cyclical?

There are many explanations to this. I discuss them in my classes. But, a nice and elegant explanation was offered by Mr. Fabrizio Saccomanni, former Minister of Economy and Finance in Italy at a BIS Special Governors’ Meeting in Manila in February 2015 and I quote:

As I have argued in the past (Saccomanni 2008), although global financial intermediaries operate in a highly competitive environment, they have uniform credit allocation strategies, risk management models and reaction functions to macroeconomic developments and credit events. Thus, competition and uniformity of strategies combine, in periods of financial euphoria, when the search for yield is the dominant factor, to generate underpricing of risk, overestimation of market liquidity, information asymmetries and herd behaviour; in periods of financial panic, when the search for safe assets is predominant, they combine to produce generalised risk aversion, overestimation of counterparty risk and, again, information asymmetries and herd behaviour. [Link]

Nice. I like it. The statements are testable hypotheses. I like it because I have long held the view that competition in the financial services industry is not the same as competition elsewhere in the real world. That does not mean that the optimal number of firms in the banking industry is ONE but that competition requires regulation and ‘leaning against the wind’ norms – countercyclical credit buffers come to mind – to ensure that competition in the banking industry is not welfare-subtracting for the economy.