Thursday, July 22, 2010 0 comments ++[ CLICK TO COMMENT ]++

Grantham shifts ever so slightly towards the deflation camp

Well, I, for one, am more or less willing to throw in the towel on behalf of Infl ation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the “fl ation” issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increase dramatically, given the fl oods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and infl ation seems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or fl at prices are the prospect for the immediate future.
The above quote, by Jeremy Grantham, comes from his latest quarterly letter ("Summer Essays", GMO Quarterly Letter, July 2010.) This is a surprising and sudden move but I should note that Grantham is only taking a short-term stance. It appears he is still betting on inflation in the medium to long-term. GMO's 7-year forecast hasn't changed much, with expectation of high returns from US "high quality*" and emerging markets.

Note that the listed returns are real returns and they are annual returns for 7 years so they are far better than they look. Basically Grantham is expecting historically high returns for US "high quality" and emerging markets. If you think inflation is going to be 3%, you are looking at those assets posting around 10% per year, which is close to what the market posted during the bubbly 90's.

I'm curious to see if Grantham tilts towards deflation in the medium to long run as well (I take long run to mean 10 years here.) In a mild-deflation/low-inflation scenario, it would be hard to see how anything can post around 7% real returns for 7 years—high quality or not. I don't think these forecasts would hold up if we get a mild-deflation-type environment.

I will note, though, that Grantham has most of the other assets, such as US large cap and small cap, at low returns (less than 3% real annualized) so it's not as if he is totally bullish.

Sticking to one of his favoured assets, Grantham expects timber to post spectacular returns over the next 7 years. Timber is expected to post 6% annualized real return within a range of +/- 5.5%. Timber is widely ignored by investors because it's hard to invest it in and it's not sexy (nothing more boring than watching trees grow ;) ) but it has strong historical record. So I think it has a shot at doing reasonably well. However, I don't think it will do well if we get low inflation with bouts of short deflation. This runs counter to what Grantham says,
Forestry remains, in my opinion, a good diversifi er if times turn out well, a brilliant store of value should infl ation unexpectedly run away, and a historically excellent defensive investment should the economy unravel. Otherwise, I hate it.
I don't agree with the latter part of the first sentence. I know timber has been defensive during bad times in the past but I have a feeling it will be marked down if we get a deflationary-type environment. Timber may have also lost some macro winds that helped it in the past. In particular, it's difficult to see timber for housing construction being anything like the last 30 years, and newsprint used by newspaper companies is likely in a long-term secular decline (possibly towards complete obsolescence.)


* I put "high quality" in quotes because it is an abstract notion that is hard to pin down for newbies such as myself. In my eyes, it's difficult to say what is high quality, except in hindsight. Someone would have said Pfizer is very high quality 10 years ago yet it is questionable right now. Similarly, five years ago, many would probably have argued that Nokia was high quality yet I'm not sure how many still maintain that view. Or how about Kraft, a company that appears to be going nowhere and destroying shareholder wealth on empire-building?


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