Inflation expectations have subsided during the last two years. In July 2024, the US consumer price index was 2.9% compared to the prior year. According to the Federal Reserve Bank of New York’s Survey of Consumer Expectations READ MORE
Prepare for All Eventualities
In “The Gentleman” series on Netflix, a young British army officer named Eddie Horniman finds out that his father has died in England. When he returns home for the funeral, READ MORE
GMO is Cautious but Selectively Optimistic
Jeremy Grantham, co-founder and chief investment strategist of GMO LLC, has an excellent reputation among investment managers due to many of his prescient statements of the past. He and his asset allocation team garner attention when they publish their commentary and 7-year forecasts on asset class returns. GMO is currently cautious about the US stock market but selectively optimistic about pockets of opportunity. Their comments reflect a defensive stance at the present time.
In his March 11 commentary, Jeremy Grantham writes that “the U.S. is really enjoying itself if you go by stock prices. A Shiller P/E of 34 (as of March 1st) is in the top 1% of history. Total profits (as a percent of almost anything) are at near-record levels as well. Remember, if margins and multiples are both at record levels at the same time, it really is double counting and double jeopardy.” However, while U.S. stocks are generally overpriced, he believes that there are some relatively attractive investments. He highlights quality, resource, and deep value stocks.
Quality stocks are defined at GMO as stocks with a high stable return on equity and a strong balance sheet. Grantham argues that they have “a long history of slightly underperforming in bull markets and substantially outperforming in bear markets.”
Grantham likes resource stocks that provide raw materials which are finite and getting scarcer. He also likes the diversification benefits because “at longer horizons (10 years) resources are the only sector of the stock market to be negatively correlated with the broad stock market.”
There has been a divergence in valuations among U.S. stocks. Deep value stocks (the cheapest 20% of the US market) “are in the best 7% of their range” while the most expensive 20% of U.S. stocks “are in the worst 10% of their 40-year range (compared to the top 1000 stocks).”
As of February 29, 2024, GMO is forecasting an annualized real return (for 7 years, after inflation) of -4.1% for US large cap stocks and -2.6% for US small cap stocks. They have higher expectations for international stocks, with a range that varies from a low of 1.1% for international large cap stocks to the highest ranked category of emerging market value stocks at 5.8% (after inflation, in local currency terms). In terms of US dollars, GMO expects an additional 2 to 4% per year from currency gains for international stocks.
GMO has modest expectations for fixed income. At the end of February, their 7-year forecast for fixed income has real returns (after inflation) for U.S. bonds and U.S. inflation-linked bonds of 1.7%. The highest ranked category is emerging debt at a 3.5% real return.
GMO does not provide any forecasts for precious metals, but they are starting to receive more attention. Central banks and investors continue to buy gold, primarily due to the rapid growth of US government debt and interest expense. Also, the geopolitical landscape is changing and the world is less willing to follow America’s lead.
Silver demand is picking up as well. India imported a record 2,200 metric tons of silver in February 2024, a portion of which will be used for lithium-ion battery production at a new factory.
If you would like to read more research directly from GMO, it is available to the public here: https://www.gmo.com/americas/
If you have any questions or comments, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Reading the Fed’s Tea Leaves
Financial markets price securities based upon future expectations. Based on the shape of the yield curve, financial markets reflect anticipation of the Federal Reserve (Fed) cutting rates aggressively in response to a recession. Given the recent market rally and high equity valuation levels… READ MORE
The Inflation Inflection Point
There was a positive reaction by the financial markets to Federal Reserve Chairman Powell’s comments on Wednesday this week. He said, “The time for moderating the pace of rate increases may come as soon as the December meeting.” The last four rate hikes to the fed funds rate have been 75 basis points (0.75%), so he is indicating a rate hike of 50 or 25 basis points at the conclusion of the Federal Open Market Committee meeting on December 14. The current fed funds rate target is 3.75-4.0%.
The financial markets paid less attention to Chairman Powell’s other remarks, which reflect the Federal Reserve’s concern of reducing inflation. After his comment about the December rate hike, he said, “History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”
Goldman Sachs strategists are forecasting a peak federal funds rate of 5.25% in May following a 50 basis point hike on December 14 and three more 25 basis point hikes next year. Most economists expect inflation to trend lower as interest rates peak and supply constraints ease.
Rob Arnott, Partner and Chair of Research Affiliates and his partner, Omid Shakernia, recently published an article, “History Lessons: How ‘Transitory’ Is Inflation?” The full article is located here: https://www.researchaffiliates.com/publications/articles/965-history-lessons. Their conclusion is contrary to the consensus. They cite a meta-analysis of 67 published studies on global inflation and monetary policy by Havranek and Ruskan (2013) which found that across 198 instances of policy rate hikes of 1% or more in developed economies, the average lag until a 1% decrease in inflation was achieved was roughly 2 to 4 years.
Arnott and Shakernia conducted their own study and examined all cases where inflation surged above 4% in 14 OECD developed economy countries from January 1970 through September 2022. Their study focused on the level and trend of inflation. Their conclusion had the following key points:
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The US Federal Reserve Bank’s expectations for the speed of reverting to 2% inflation levels remains dangerously optimistic.
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An inflation jump to 4% is often temporary, but when inflation crosses 8%, it proceeds to higher levels over 70% of the time.
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If inflation is cresting, inflation levels of 4 or 6% revert by half in about a year. If inflation is accelerating, 6% inflation reverts to 3% in a median of about seven years, threatening an extended period of high inflation.
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Reverting to 3% inflation, which we view as the upper bound for benign sustained inflation, is easy from 4%, hard from 6%, and very hard from 8% or more. Above 8%, reverting to 3% usually takes 6 to 20 years, with a median of over 10 years.
Arnott and Shakernia believe that the consensus view that a short “transitory” period of high inflation will soon pass places too high a probability on the best case and ignores economic history.
If you have any questions or comments, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA