July 20, 2010
The following is a summary of Jeremy Grantham's 2Q 2010 newsletter, published July 20, 2010.
- Portfolio Outlook and Recommendations. A weak loan supply and fairly weak loan demand have slowed the velocity of money, and made inflation a distant prospect. A weak economy and declining or flat prices are likely for the immediate future. Meanwhile, policymakers in Europe and the U.S. seem to be emphasizing debt reduction over economic stimulus. This combination of market weakness and fiscal conservatism makes the current slowdown downright frightening. A global equity portfolio with annual returns of 6 percent plus inflation is still possible, however, by overweighting high quality U.S. stocks and underweighting other U.S. stocks. U.S. high quality stocks should earn 7.3 percent real annual returns over the next seven years, followed by emerging market equities at 6.6 percent returns. Emerging market fundamentals continue to outstrip developed markets. Forestry remains a good diversifier if times turn out well, a good store of value if inflation runs away and a good defensive investment if the economy unravels.
- Finance Goes Rogue (But Volcker Wins a Round!) In 1965, the financial services industry accounted for just 3 percent of U.S. GDP. By 2007, the industry had expanded to 7.5 percent. The extra 4.5 percent of the pie that went toward financial services in 2007 seems to have amounted to a tax on the real economy that reduced its ability to save and invest. The long-term trend toward deregulation of the financial services sector seems in hindsight to have guaranteed a major financial bubble sooner or later. Information asymmetries between banks and institutional investors remain a problem. Luckily, the Volcker provisions included in the financial reform bill currently in Congress could help reign in speculative investments by banks that are not on behalf of their customers.
- The Fearful, Speculative Market. Despite growing nervousness and a slowing economy, there is still a 45 percent chance thanks to low interest rates that the S&P 500 will rise above 1,400 by October of next year, accompanied by a speculative spin. High quality stocks have been cheap for five years, and may spend most of the next several years underpriced, bouncing back up to fair value from time to time.
- Everything You Need to Know About Global Warming in 5 Minutes. While global warming will be the most important investment issue for the foreseeable future, how to make money from it is not yet clear. Climate science is a swift-moving field rife with treacherous politics, and there will be many failures. It would be easier to market a "climate" fund than to outperform with it.
- "Seven Lean Years" Revisited. The idea behind the "seven lean years" hypothesis is that it will be impossible to overcome many of the problems facing developed countries, including the U.S., in fewer than seven years. These problems include the over-indebtedness of consumers, the shift of financial sector debt to the government, the end of artificial stimuli, leverage in the European financial system, runaway costs in the public sector, high unemployment, trade imbalances, a lack of competitiveness among the PIIGs (Portugal, Ireland, Italy Greece and Spain) countries relative to Germany, a loss of faith in currencies due to rising sovereign debt levels and widespread over-commitments to public pension and health benefits.
- Aging Populations, Pensions and Health Costs. The cost-laden U.S. health care system is fine if you are willing to pay for it. Interestingly enough, however, the same people who cry "death panel" at the mention of rationing also seem to reach for their pistols at the prospects of higher taxes. This refusal to make difficult choices has put the U.S. near the top of the list of countries with major financial problems. Meanwhile, an aging population means that a greater percentage of GDP will soon be consumed by retirees through pension payments, while a smaller percentage will go to younger workers. Two things we can do to prepare for this demographic shift are to make any necessary investments in infrastructure now, before pension costs rise, and to pay off our debts as soon as possible.
To read the full commentary, go to www.gmo.com