GMO Quarterly Letter

Is Trump a Get Out of Hell Free Card?
No, but he may help us get out of Limbo

Ben Inker

The new administration’s plan for a large fiscal stimulus seems poorly designed, oddly timed, and very unlikely to produce the sustained strong growth that Trump claims he will provide. Even in the unlikely possibility that we do achieve the growth Trump is calling for, it is not obvious that it would be the boon to the stock market that investors seem to think. The fiscal stimulus does, however, seem likely to lead to tighter monetary policy and has a reasonable chance of leading to rising inflation. How the economy responds to these two potential outcomes will tell us a good deal about whether the Hell or Purgatory scenario is correct, which will be helpful to investors even if the policies themselves prove not to be.

Last quarter’s letter, “Hellish Choices: What’s An Asset Owner To Do?” discussed what I consider to be the most momentous investment question facing asset owners today. Will asset prices revert to valuation levels similar to historical norms, leading to bad returns for a while but long-term returns similar to what investors have been trained to expect? Or have we seen a permanent shift such that asset class valuations have permanently risen and long-term returns available from them have consequently fallen? Such a shift would be a profound problem for the basic rules of thumb used by almost all long-term investors, but in the shorter run means returns will not be disastrously bad. The key metric that I believe has driven market valuations upward in recent years and could conceivably drive them right back down is short-term interest rates: So much of this comes down to a question of whether cash rates over the next 10, 20, or 50 years will look like the “old normal” of 1-2% above inflation or whether they will look more like the average of the last 15 years of about 0% after inflation. The scenario where they average 0% real is what we have referred to as “Hell,” whereas the other scenario is “Purgatory.” On the eve of the US election in November, the US 10-year Treasury Note was yielding about 1.55%, which suggested the bond market at least was very much in the Hell camp. As of year-end, that yield has risen 90 basis points to 2.45%, which is at least closer to a level consistent with Purgatory. This has led a number of our clients to ask us if we have changed our minds about the likelihood of Hell, as the market seems to have. The short answer is that we have not. If Hell is a permanent condition for markets, it should not be readily changeable by the policy choices of a single US administration, to say nothing of the fact that we do not yet know what those policy choices will be for an administration that has just taken office.

But the basic dilemma of “Hellish Choices” was not strictly about Hell, it was about the uncertainty as to whether we are in Hell or Purgatory, given the two have quite different implications for both portfolios today and institutional choices for the future. Keeping with the theological theme, I will call that state of uncertainty “Limbo.” A certain unpleasant outcome is not something to be excited about, but it is at least something you can try to prepare for. Uncertainty that has important implications for your portfolio is another matter entirely, and the most important implication of the Trump administration is not that it has removed the possibility of Hell from our investment forecasts, but that it gives us some hope that we may be able to figure out whether we are in Purgatory or Hell within the next few years. That does, at least, get us out of Limbo.

Two scenarios for how we got here
It is certainly the case that bond yields are becoming more consistent with a Purgatory outcome and the Fed’s “Dot Plot” was always consistent with it, but it was never really the Fed or the bond market that made us reluctantly contemplate a future of permanently low interest rates. Rather, it has been the extended period of time in which extremely low interest rates, quantitative easing, and other expansionary monetary policies have failed to either push real economic activity materially higher or cause inflation to rise. The establishment macroeconomic theory says one or the other or both should have happened by now. It seems to us that there are two basic possibilities for why the theory was wrong. The first is a secular stagnation explanation of the type proposed by Larry Summers and others.1 This line of argument can be boiled down to saying that the reason why exceptionally easy monetary policy has not been particularly stimulative and/or inflationary is that the “natural” rate of interest has fallen to extremely low levels relative to history. This means that the apparently extremely easy monetary policy has not, in fact, been particularly easy. Consequently, we should not have expected a huge response from the economy or prices. If this argument is correct (and secular stagnation is a reasonably permanent condition for the developed world, not just a temporary effect of the 2008-9 financial crisis), then we should see that as interest rates rise to levels that are still low by historical standards, they will choke off economic growth. Part of the plausibility of this argument comes from the fact that debt levels have grown steadily and massively in most of the developed world over the last 30 years, so it is easy to imagine that indebted households and corporations could run into problems if rates were to back up even 200 basis points from the recent lows.

The second possibility for why extraordinarily easy monetary policy has not had the expected effects on the economy and prices is an even simpler one: Monetary policy simply isn’t that powerful. This line of argument (which Jeremy Grantham has written about a fair bit over the years) suggests that the reason why monetary policy hasn’t had the expected impact on the real economy is that monetary policy’s connection to the real economy is fairly tenuous. There is no question that monetary policy affects the financial economy. Corporations may or may not have changed their investment and R&D decisions based on the level of interest rates, but low rates have certainly encouraged borrowing to pay for stock buybacks. But, as Jeremy has pointed out, if debt increases and easy monetary policy are such a boon to economies, why haven’t we seen any boost to growth as debt has grown relative to GDP? Exhibit 1 is an old favorite of Jeremy’s, showing GDP growth and debt to GDP for the US over time. The build-up of debt since the 1980s certainly hasn’t coincided with a speed-up in GDP growth, or even evidence of an economy straining to run faster than its potential growth rate.

The secular stagnation argument implies there must be something important wrong with the economy such that even the build-up of debt hasn’t been able to get growth any higher than it has. The alternative explanation is that debt just doesn’t matter that much. The productive potential of the economy is built out of the skills and education of its workforce and the depth and technology of its capital stock. The way that capital stock was financed may be of academic interest, but has no bearing on what we can expect it to produce. If that is true, then the various ways monetary policy impacts the economy are unlikely to be that meaningful.

Implications of the two scenarios
So we have two competing hypotheses that can both explain how we got to this point. The nice thing is that they would have quite different implications as we go forward from here. If the secular stagnation theory is correct and equilibrium interest rates have fallen a lot, we should expect to see rising interest rates slow the economy considerably, and the Federal Reserve will find itself unable to raise rates as much as it is planning to. The economy will either slide back into recession, causing rates to come right back down, or we will settle into such a precarious low-growth mode that it will stop raising rates by the time we get to 2% or so on Fed Funds. Such an outcome would be at least suggestive that we are in Hell. But winding up in recession in the next couple of years is not an iron-clad guarantee we are in Hell. If it is possible for an expansion to die of old age, the current one is getting pretty old and might be due for death by natural causes. And there is also a meaningful possibility that either external events or other aspects of government policy – protectionist policies leading to a global trade war, perhaps – could push us back into recession. So cause of death for the expansion will be very important to know, should it occur.

If, on the other hand, the “monetary policy doesn’t matter” explanation holds true, then the economy has every reason to power through the Federal Reserve’s gradual rate rises without too much trouble. We probably will begin to read analyses of the financial crisis and the years after which suggest that while some of the emergency measures helped to get the banking system functioning again in the immediate aftermath of the crisis, quantitative easing and ultra-low interest rates did not do that much for the economy in the end. This will likely bleed into pieces pointing out that if monetary stimulus isn’t all that effective in boosting the real economy, it should be used sparingly because its impacts on the financial economy are very significant and generally negative for financial stability, given how it encourages leverage, speculation, and asset bubbles.2

If the economy remains reasonably strong, we should expect the Fed Funds rate to rise at least to the level of the “Dot Plot” of around 3%, and quite likely higher. This will, of course, push up bond yields. Higher bond yields will provide some competition for stocks in portfolios and the higher cost of debt will discourage corporations from taking on ever-increasing amounts of debt in order to buy back stock. P/Es may, at long last, come back down to levels consistent with their longer history of somewhere in the middle to upper teens. Investment portfolios will take a hit, but we will at least be back to a level of valuations where investors can expect to earn the kinds of returns they need in the long run. It will be Purgatory, and while Purgatory is painful, it is finite.