Filling in for Jeremy Grantham in the new edition of the GMO quarterly, find Ben Inker’s take on tapering and the stock market. Excellent as usual.
To investors focused on U.S. equities, it may be easy to forget the investing excitement of this spring, but for others, particularly anyone running a portfolio predicated on asset class correlations being low, this has been a pretty shocking couple of months. From May 22 to June 24, the S&P 500 lost 5.6%, MSCI EAFE lost 10.1%, MSCI Emerging fell 15.3%, the Dow Jones/UBS Commodity index fell 4.5%, the U.S. 10-year T-Note fell 4.4%, and the Barclays U.S. TIPS index fell 7.1%. For good measure, the J.P. Morgan Emerging Debt Global index fell 10.8%, the German 10-year Bund fell 5.2%, the UK 10-year Gilt fell 3.4%, and the Australian 10-year bond fell 6.5%. Equity markets have made a fairly sharp recovery since then, with the S&P 500 actually hitting new highs, but lots of other asset classes are still licking their wounds. In light of the generally negative correlations between stocks and bonds of the last decade, the universality of the declines looks pretty weird. For those schooled in thinking that the only “risks” that matter for investors are growth shocks and inflation shocks, it’s significantly more than just weird. To anyone of that mind, it’s a bit of a soul-searching moment, and it forces you to either treat the episode as a one-off event that will hopefully not happen again anytime soon or as a challenge that requires you to rethink your risk model. Not surprisingly, at GMO we believe it to be the latter, and that most investor risk models are missing an important piece of the puzzle.
This is not to say that growth shocks and inflation shocks don’t matter. They do, as they are two of the basic ways investors can lose significant amounts of money in otherwise diversified portfolios. Risk assets generally lose money in depressions, and nominal assets generally lose money in unanticipated inflations. But there is a third way to lose money, and it was what bit the financial markets in May and June. We call it valuation risk at GMO, and it is the risk associated with the discount rate on an investment rising. It can impact a single asset class for idiosyncratic reasons, but it can also affect a wide array of asset classes for a systematic reason. This spring it affected a wide array for a systematic reason.
The proximate cause of the decline was a statement given by Fed Chairman Ben Bernanke to Congress that quantitative easing would taper down within the next few Federal Reserve meetings if economic data continued to improve. Bernanke clearly did not mean for the market to freak out over the statement, as can be seen in the frantic backpedalling offered by various Fed governors, including Bernanke himself, in the following weeks.But freak out the market did, and not just one market, but seemingly all of them. Why?
If he was of a mind to, Bernanke could choose to consider the whole thing a compliment. It is only because markets all around the world have been doing what he has asked them to that his words had the impact they did. Bernanke has been quite clear that a major purpose of easy monetary policy, and quantitative easing in particular, is to prod investors to bid up the prices of assets. In this, he has succeeded, even if it has not had the knock-on effects on the real economy that he might have hoped. To understand what has gone on, it is helpful to look at our 7-year forecasts in a way that we don’t normally show them.
Exhibit 1 shows our estimated equilibrium returns for asset classes as a scatterplot with expected return on the vertical axis and expected volatility as the horizontal axis.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.