GMO 4Q16 Letter: Trump, Rates, Valuation, Stock Market, US Class War


GMO Quarterly Letter, 4Q16

Is Trump A Get Out Of Hell Free Card? No, but he may help us get out of limbo
Ben Inker

  • Large fiscal stimulus of new administration seems poorly designed and oddly timed but seems likely to lead to tighter monetary policy and lead to rising inflation
  • Most momentous investment question facing asset owners today: will prices revert to valuation levels similar to historical norms, leading to bad returns for a while but long-term returns similar to what we have been trained to expect? Or have we seen a permanent shift such that valuations have permanently risen and long-term returns have fallen?
  • Key metric that has driven market valuations in recent years and could conceivably drive them right back down is short-term interest rates: will cash rates look like old normal of 1-2% above inflation or average of last 15 years of 0% after inflation?
  • On the eve of US Election, 10-year treasuries were yielding 1.55%; at year end, risen 90 bps to 2.45%
  • Most important implication of Trump administration is not that it has removed the possibility of permanent low interest rates and high asset prices but that it gives us some hope that we may be able to figure out which direction we are headed to (asset prices, cash rates)

Two scenarios for how we got here

  • What made us contemplate a future of permanently low interest rates has been extended period of low interest rates, quantitative easing, and other expansionary policies that have failed to push real economic activity or cause inflation to rise
  • Why was macroeconomic theory wrong? Two theories:
    • Secular stagnation: “natural” rate of interest has fallen to extremely low levels – if this is true, rising interest rates will choke off economic growth
    • Monetary policy simply isn’t that powerful: no question that monetary policy affects financial economy but build-up of debt since 1980s certainly hasn’t coincided with a speed-up in GDP growth


Implications of the two scenarios

  • Two scenarios have quite different implications as we go forward from here
  • If secular stagnation theory is correct: expect to see rising interest rates slow the economy considerably, and Fed will be unable to raise rates as much as it is planning; economy will either go into recession or we will settle into a precarious low-growth mode
    • If it is possible for an expansion to die of old age, cause of death for the expansion will be very important to know, should it occur
  • If monetary policy doesn’t matter explanation holds true, economy has every reason to power through the Fed’s gradual rate rises without too much trouble; people will point out that monetary stimulus should be used sparingly because is not effective and encourages leverage, speculation, and asset bubbles
  • If economy remains reasonably strong, Fed Funds should rise to at least around 3%, bond yields will go up, bond yields will provide competition for stocks, buying back stocks by using leverage will stop, P/E ratios will fall – investment portfolios will take a hit but we will at least be back to valuations where investors can expect to earn long-term returns they need

What if Trump succeeds?

  • This all assumes that administration’s attempt to push the economy up to 3.5-4.0% growth fails; why do we think US is unlikely to achieve sustained growth like 3.5% and what happens if they actually succeed?
  • Productivity growth trending south of 1.5% and population growth to add somewhere between 0.2-0.5%; while it is tempting, return to 3% productivity growth is a pipe dream
    • Attempting to grow a 1.5-2.0% economy at 4% is a recipe for inflation
  • Any acceleration of inflation will require far faster interest rate increases than is generally being priced in and will learn quickly whether economy can withstand those increases
  • If we assume that economy actually grows at 3.5-4.0%, this will not be the panacea for equity investors that some are assuming
    • Seems more or less impossible that the right interest rate level for an economy growing at 4% would be 0% real
  • Corporate revenues will grow significantly faster but may well be associated with stock market trading at significantly lower valuations


  • Slowdown in productivity growth didn’t hurt corporate profitability so a hypothetical increase in productivity may not push up profitability
  • For an economy in which consumption is 70% of output, necessary condition of sustained economic growth would be the share of income going to labor going up (which brings down corporate profitability)
  • What about cut in corporate tax rates?
    • Very possible that it will be positive for stock market; it is neither theoretically clear nor empirically obvious that tax rate changes have been particularly important to profitability
    • Tax rates did their falling in the 1980s and profit spike was a good 20 years later
    • Tax rate falls have been generally associated with falling, not rising, profits


The Road To Trumpsville: The Long, Long Mistreatment Of The American Working Class
Jeremy Grantham

  • Pushback against the rich and powerful for several decades has been very wimpy
  • “Occupy Wall Street” aside, average voter sat still for a series of major tax cuts for the higher tax brackets and on capital; lower income workers paid the cost of outsourcing and labor-saving technology but received no material help; global forces pushed wages down and politics pushed them deliberately lower
  • GDP going to labor hit historical lows and the share going to corporate profits hit a simultaneous high


  • Complete lack of influence that voter opinion had on probabilities of any bill passing through Congress:
    • If favored by the 31% average public, chance of passing rose to 32%; if not favored, fell to 30%
    • When favored by the richest 10%, bills passed at a 65% rate
  • To promote pushback against excessive corporatism, one needs to first recognize the problem
    • With this election, the point has been finally made that we need to be saved from the rich and powerful
    • We live in a different world now: a world in which a degree of economic struggle between the financial elite, perhaps 10% but more likely 1%, and all the rest is finally recognized
  • 45,000 people participated in a large exit poll run by Reuters/Ipsos in the early evening of election day (detailed poll): never heard of a vote so uniform
    • Whether Republican 72% or Democrat 77%; Male 74% or Female 75%; White 75% or Black 74%; Rich 70% or Poor 79%; Christian 74% or Muslim 72%; Graduates 68% or not 76%; they all agreed that they had it with the rich and powerful
  • Trump recognized this streak and played to it, clearly stating his intention to look after the forgotten workers; Clinton diffused her message as looking after almost everyone
  • Lack of class war or economic war in the US has always been a fiction, but it has been mostly hidden
    • New administration is surrounded by capitalists and billionaires who are apparently prepared to wage war on regulations and direct tax cuts for the rich and corporations
    • You probably can’t bamboozle enough of the people enough of the time
Source: GMO
Image Source: Getty Images

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