GMO Quarterly Letter

Hellish Choices: What’s An Asset Owner To Do?
Ben Inker

Executive Summary
Given today’s low yields and high valuations across almost all asset classes, there are no particularly good outcomes available for investors. We believe that either valuations will revert to historically normal levels and near-term returns will be very bad, or valuations will remain elevated relative to history. If valuations remain elevated indefinitely, near-term returns will be less bad but still insufficient for investors to achieve their goals. Furthermore, given elevated valuations in the long term, long-term returns will also be insufficient for investors to achieve their goals. It would be very handy to know which scenario will play out, as the reversion versus no reversion scenarios have important implications both for the appropriate portfolio to run today and critical institution-level decisions that investors will be forced to make in the future. Unfortunately, we believe there is no certainty as to which scenario will play out. As a result, we believe it is prudent for investors to try to build portfolios that are robust to either outcome and start contingency planning for the possibility that long-term returns will be meaningfully lower than what is necessary for their current saving/ contribution and spending plans to be sustainable.

Over the past few years, my colleague James Montier and I have written extensively on the possibility that there has been a permanent shift in the investment landscape.1 The investment landscape today is an unprecedented one, where we believe it is not so much that asset prices look mispriced relative to one another (although some of that is going on) but that almost all asset classes are priced at valuations that seem to guarantee returns lower than history. Our standard forecasting approach assumes that this situation will gradually dissipate, such that seven years from now valuations will be back to historical norms. James calls this scenario Purgatory because it means a finite period of pain, followed by a return to better conditions for investors. An alternative possibility, which James refers to as Hell, is that valuations have permanently shifted higher, leaving nearer-term returns to asset classes somewhat better than our standard methodology would suggest, but at the expense of lower long-term returns. By now some of our clients are probably thoroughly sick of hearing about the topic, but this piece is going to delve into it yet again, because the question of whether we are in Purgatory or Hell is a crucial one, not only for its implications for what portfolio is the right one for an investor to hold at the moment, but also for the institutional choices investors have to make that go well beyond simple asset allocation. In his letter this quarter, Jeremy Grantham is exploring a slightly different version of the Hell scenario. His version of Hell is driven more by weaknesses in the arbitrage that should force asset prices back to equilibrium rather than changes to discount rates, but it has similar implications for investors and institutions.