Jeremy Grantham Weighs In on Where We Stand and What is to Come

I recognize Jeremy Grantham as a very intelligent person, and always take time to ruminate on his opinions at considerable length.  Although not quite headline news any more, as it was released in January, GMO's Quarterly Letter is definitely worth a read.  Mr. Grantham speaks highly of the re-emergence of Volcker in the regulation debate, and very lowly of the Supreme Court ruling to remove caps on corporate political donations (ironically, in defense of free speech - who are they kidding?).  But I digress.

Given that his publication marked the turn of the decade, Mr. Grantham offered his opinions on what the coming decade had in store, as well as reviewing his firm's predictions over the last decade.  Looking forward, Mr. Grantham is not particularly optimistic:

"I still believe that after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios, so that it would feel more like the bumpy (bumpy, but not so disastrous) 1970s than the economically lucky 1990s and early 2000s."

Broadly, I agree with this forecast, which is quite similar to that of Mr. El-Erian of PIMCO (more on Mr. El-Erian in some other post).  Admittedly, the conclusions of his analysis are not particularly novel.  However, I consider the following observations particularly astute.

"Now, though, after our massive stimulus efforts, the Fed’s balance sheet is unrecognizably bad, and the government debt literally looks as if we have had a replay of World War II. The consumer, meanwhile, is approximately as badly leveraged as ever, which is to say the worst in history. Given this, we would be well advised to avoid a third goaround in the bubble forming and breaking business. Up until the last few months, I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and financial system. Now, however, the penny is dropping, and I realize the Fed is unwittingly willing to risk a third speculative phase, which
is supremely dangerous this time because its arsenal now is almost empty." (Grantham's emphasis)

As far as I am concerned, it is this insight which should be the crux of any policy debate moving forward.  There really is no room for error moving forward.  In "This Time is Different", Reinhart and Rogoff calculated that government debt expands 86% in the 3 years following a domestic banking crisis.  Assuming history is any guide (a classic folly, but current deficit figures are mind-numbing, lending support to Reinhart and Rogoff's findings) this implies that there won't be any more room on the government balance sheets to bear the costs of any further crises.  The Fed's balance sheet stands at $2.4 trillion.  How much larger can it realistically get without threatening the government's financial integrity? While there are strong arguments for extreme monetary stimulus, every meeting the Fed decides to hold off on raising rates, they increase the probability of inflating another asset bubble.  This has the effect of inching the global economy (back) towards the precipice through the heightened risk of future asset bubbles, while simultaneously hauling it from the brink via extremely accommodative monetary policy.  Are the benefits of loose monetary policy worth the risk of catastrophe in the form of another ugly asset bubble?  I cannot claim to have this grand calculus mastered, but I sure would like to hear this question being asked a little more often.

Back to Grantham's piece.  From this discussion, he ruminates on where investors may find value in the coming decade, as well as reviewing his calls from the end of 1999, which are amazingly accurate.  For those who don't have time to read it, he considers the S&P 500 to be worth something around 850 (keep in mind that this was published in January and therefore this figure may have changed).  Definitely worth the half hour it will take to read the report in its entirety.