James Montier on 'The Purgatory of Low Returns'VW Staff
The latest white paper from GMO features articles from James Montier and Ben Inkler. Full document can be found below.
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.