GMO's Inker: Bullish on Medium Term, but Big Threats Loom

Q&A January 28, 2019 at 03:39 PM

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Slowing earnings growth proves that the long bull market "deserves to be over," argues GMO's portfolio manager Ben Inker. Nonetheless, the head of the firm's asset allocation team is more bullish about making "good money" for clients in the medium term than he's been in years, he tells ThinkAdvisor in an interview.

In a wide-ranging conversation about the economy and markets, Inker stressed his continued enthusiasm for emerging markets over a multi-year period. Indeed, his return expectation for investments there is 9%-10%.

Grantham Mayo Van Otterloo and Co., founded by famed market-bubble forecaster Jeremy Grantham in 1977, chiefly serves sophisticated institutional investors, including retirement plans and endowments. Inker is also manager of the GMO-managed Wells Fargo Absolute Return Fund (WARAX).

Opining in his quarterly letter of Jan. 25, 2019, that U.S. equities and "normal government bonds" aren't among "appealing assets," Inker writes: "We believe the portfolio you should own today looks more-or-less nothing like a traditional 60% stock/40% bond portfolio."

In the interview, he commented that, in view of the lengthy U.S. economic expansion, a recession wouldn't be "that weird." But he contends that the market's recession "fixation" is "overblown."

All the same, Inker worries about what he calls the stock market's biggest near-term threat: signs of economic weakness globally, including U.S. trade tensions with China and the waning effects of President Donald Trump's tax cuts.

Longer term, "the worst thing that could happen to the stock market," he maintains, is a return of inflation. He therefore advises crossing one's fingers that a "comeback" isn't in the offing.

Inker joined GMO 26 years ago, right after graduating from Yale University. A member of the board of directors, the chartered financial analyst is responsible for allocations of GMO's multi-asset portfolios.

A current job posting for a quantitative research analyst on Inker's team describes the GMO process as "rigorous fundamental analysis with innovative quantitative methods to understand the long-term drivers of returns." Listed below the right candidate's technical qualifications: "Sense of humor is highly desirable." Clearly.

ThinkAdvisor interviewed Inker by phone on Jan. 22. Speaking from the firm's Boston headquarters, he singled out good-bet emerging markets and commented on why he's not giving Trump's job performance high marks thus far.

Here are highlights from our conversation:

THINKADVISOR: What's your broad outlook for the U.S. stock market?

BEN INKER: Despite some reasonable concerns about the global economy and that we think the U.S. stock market still isn't that attractive, we're finding lots of stuff worth buying. We're actually more upbeat about the prospect of making good money for clients over the medium term than we have been in years.

What's the biggest threat to the stock market?

In the near term, the biggest threat is strong signs of economic weakness globally, including home-grown weakness in the U.S. from trade tensions and the fact that the effects of the big tax cut are starting to fade.

What's the big threat in the longer term?

From the standpoint of valuations of stocks, bonds, real estate, infrastructure — and pretty much everything else — it would be: if it started looking like we were getting an inflation problem. That would be the worst thing that could happen to the stock market.

Why?

Inflation has been [relatively] absent in the developed world for the last 15 years or so. Was that temporary or a permanent shift? If it's temporary, the problem of inflation will eventually come back — and, man, that's going to do a number on stock valuations and bond yields and real estate prices — everything. You've really got to be crossing your fingers and hoping that inflation isn't going to make a comeback.

What else has gone into your outlook for the market this year?

Our general view has been that the stock market owes very little to our forecast for the economy and a lot more to the fact that the U.S. stock market still looks quite highly valued — much more expensive than markets in the rest of the world. Over the medium term, it's hard to expect a lot out of the stock market no matter what the economy does.

So is the long bull market over?

It deserves to be over. Our fear for the U.S. stock market is [based on the fact] that the only way to get really strong earnings growth is if earnings are growing relative to GDP. But GDP is unlikely to grow all that fast. The growth rate of the U.S. economy has slowed considerably in the decade since the financial crisis. And there certainly has to be some limits to earnings growth relative to GDP.

Where does that stand at present?

We're definitely approaching those limits; going forward, profits should grow more slowly than GDP. The market is going to wind up disappointed by the fact that if earnings can grow at 2% real over the next decade, that would be a pretty good outcome. The stock market doesn't like being disappointed. So if we start getting signs that a recession is in the offing, it would go down.

How realistic is the fear that a recession is en route?

It's realistic. But the market's fixation on recession is overblown. People have a tendency to overestimate how much recessions matter. The recession of 10 years ago was the worst since the Great Depression. But most recessions come and go, and don't have lasting impact.

Do you see a recession on the way?

It wouldn't be that weird to get a recession — this has been an extraordinarily long economic expansion by historic standards. If we got one that didn't occur alongside a greater financial crisis, it would make profits fall for a while and unemployment rise, but five years [later] nothing really meaningful would have changed.

Where do rising interest rates enter the picture? The Federal Reserve has increased rates but indicated that it is now slowing down the pace.

The uncertainty about inflation leads to a lot of uncertainty about what the appropriate level of interest rates is. With rates a couple of points higher than a few years ago, housing activity and car buying have slowed. You'd expect those two segments of the economy to be, kind of, the canary in the coal mine.

What are your further thoughts on rates?

What's harder to know: Is the slowdown simply the result of the removal of artificial stimulus or a sign that the semi-mythical neutral level of interest rates is at or below where we are now? Frankly, there's something a little bit sad about the idea that interest rates of 2% are enough to choke off economic activity.

Are you worried about the flat yield curve?

That's more a symptom of market concerns than a cause of economic weakness. The flat yield curve is the market's reacting to what it sees as economic weakness — it's showing its nerves.

What's your forecast for bonds, then?

With a "nice" flat yield curve, it's hard to be really excited about bonds from here. We prefer both cash and TIPS [Treasury Inflation-Protected Securities] to traditional government bonds.

What market sectors do you like?

We're quite bullish on emerging markets on a multi-year basis. Lots of assets had a bad year, and the nice thing about a bad year is that it makes valuations significantly cheaper.

You've liked emerging markets for a while.

I like them better now — they're cheaper. If you take an asset that I like and mark it down 15%, I'm generally going to like it more. Right now, broadly, emerging markets are fairly valued relative to history. The cheap half of the market is cheaper than historically normal levels and is trading at levels that we think deserves to give a return of close to 10%. That's pretty exciting.

What else makes emerging markets even more appealing to you?

Emerging debt is a lot more attractive than it was. Lots of things that have an underlying cash return have gotten a lot more attractive. So we like alternatives significantly better than we did a year or two ago for the simple reason that with cash rates a couple of hundred basis points higher, it's easier to earn a decent return.

Which emerging markets do you like?

Cheap stocks can be found all over the emerging world — places like Russia and Turkey that nobody wants to touch. But you can also find them in places like Korea or Taiwan or China or Brazil. It's pretty easy to put together a portfolio trading at nine times earnings, and that's the kind of thing that gets us excited.

What about other countries of the world?

The stock markets of Europe, Japan, the U.K. and Australia got a lot more attractive last year. They did it by going down.

Generally, emerging markets, such as the ones you've mentioned, are risky to invest in.

They're always risky because there's more risk of things going wrong. But if they're priced for bad news, you don't need really good news to get good returns out of them. If you've got a portfolio of stocks trading at nine times earnings, what you need is for earnings not to collapse. If earnings can just hang on, you get a good return.

What's the main significance of the economic slowdown in China?

That has definitely occurred. A slowing China means a slowing world [economy]. So there's every reason to be concerned about it.

What are your thoughts about the potential impact on the market of President Trump's trade battle with China?

A trade war is both recessionary and inflationary at the same time. That's a very bad combination. It increases prices, and it's a negative on demand. The stock market doesn't like inflation; nor does it like recessions. Anything that can cause them simultaneously is something to be seriously worried about. So we're worried about the lack of progress in the trade talks [with China] and the possibility of a more severe trade breakdown between the U.S. and China — and, indeed, between the U.S. and a fair bit of the rest of the world.

How important to the market are the big increases in debt that have occurred in the U.S.: corporate debt, consumer debt, federal debt?

There's potential weakness in the U.S. corporate system driven by high-level leverage. So we're a little nervous about the buildup of debt in the nonfinancial corporate sector. It means that, if interest rates go up, there's a strain on corporate cash flow.

How does the current situation compare to right before the financial meltdown?

Things don't look as scary as they did in 2006-2007, when you had a tremendous amount of debt that was built up in incredibly weak hands: entities that needed to continually go back to the market to take on more debt. Today, the corporate sector is not quite in that situation, and certainly households aren't.

Looking again at the housing market, how do you view the slowdown there?

The ability of the housing market to cause a big recession or financial crisis is a lot less than the last time around. Leverage in the financial system is a lot lower. Homebuilding is a much smaller percentage of GDP. I'm a little more concerned that housing is telling us something about the impact of historically low interest rates — but, by recent standards, suddenly higher rates than we've seen.

Please elaborate.

If it [becomes] the case that the Federal Reserve's raising rates 200 basis points is enough to drive the economy into recession, that says something negative about the health of the U.S. economy.

When we talked three months before the 2016 election, you were skeptical about the potential success of a Donald Trump presidency. Do you feel more confident in him now, or is your attitude unchanged?

Before he got elected, Trump looked like he would be more difficult to predict than other presidents, and I worried if that would be a problem. I think it proves to be one.

So how would you assess Trump's two years in office thus far?

Holding aside the way he's conducted himself from a policy standpoint, the most obvious thing that we've gotten is a big fiscal stimulus [tax cuts] at a time when the economy didn't need one. From an economic perspective, there isn't that much to talk about other than the looming threat of a trade war. That would be bad for the U.S. and indeed the rest of the world. So it's hard to give someone a good grade based on that.

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