GMO’s Montier on Why to Hold Cash

Asset allocation is the most important decision in constructing
portfolios that meet clients’ goals. Two prominent figures in the
investment world recently offered sharply different perspectives on
the most prudent approach for advisors.
Central bank policies have distorted markets to such a degree that
investors are devoid of any buy-and-hold asset classes, according to
James Montier. But according to Richard Bernstein, the flood of
liquidity unleashed through quantitative easing (QE) now offers
investors compelling opportunities.
Montier is a member of the asset allocation team at Boston-based
Grantham Mayo van Otterloo. Bernstein is the chief executive officer
of New York-based Richard Bernstein Advisors. The two squared off
in a panel discussion at the 2013 Morningstar Investment
Conference in Chicago last week.
“This is the hardest time to be an asset allocator,” Montier said.
“Normally, you find that safe-haven assets are expensive and riskier
assets are cheap – and vice versa. But today, largely because of the
central banks around the world, we’ve got a very distorted
opportunity set, such that there is nothing you can buy and hold.”
Bernstein agreed that QE has upset traditional valuation dynamics,
but he said investors still have choices.
“There are pockets that are very, very attractive,” he said. “People are generally unaware
of those pockets.”
Let’s look at the key assumptions around Federal Reserve policies that led these two
investors to such divergent views of the markets.
Fed policy and its impact on the markets
Low inflation and low interest rates have driven most asset classes to unacceptably high
valuations, Montier said.

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Montier explained that GMO uses a valuation methodology based on reversion to the
mean. It looks at metrics such as margins, earnings and sales growth, then analyzes what
the impact will be on prices if those values revert to their long-term averages over a sevenyear time horizon.
Those forecasts are published on GMO’s website. As of the end of May, stocks – with the
exception of emerging markets, which I will come back to in a moment – offered real
(inflation-adjusted) returns ranging from -3.1% to 3.4%. Bonds were even worse – only
emerging debt had a positive expected return.
The U.S. economy remains “miles away” from the Fed’s preconditions for ending its QE
measures, Montier said. The Fed explicitly stated that unemployment must fall below 6.5%
and inflation must rise to 2.5% before it will tighten. Right now, with 7.6% unemployment
and 1% inflation (measured, as the Fed does, by the personal consumption expenditure
(PCE)), Montier said it is unlikely the Fed will tighten any time soon.
Since the end of 2012, Montier said the market has made a “huge” shift, from pricing in 20-
plus years of financial repression to assuming that repression will end in the next decade.
That has resulted in a steepening of the real-interest-rate term structure.
Inflation is unlikely to accelerate, Montier said. People who fear that the Fed’s “printing
money” will lead to inflation don’t understand how QE works, he said. The Fed is buying
long-term bonds and issuing massive amounts of short-term debt, according to Montier,
which wind up in bank reserves. “There is no printing of money per se,” he said.
The velocity of money has collapsed, he said, and neither demand-pull or cost-push
mechanisms are likely to revive it and create inflation. Too much slack in the economy –
such as high unemployment – makes demand-pull inflation unlikely. Commodity prices
aren’t increasing, he said, so cost-push inflation won’t unfold. Montier said in the 1970s,
America’s highly unionized workforce drove higher commodity prices into higher wages
and prices. Unions play a smaller role in today’s workforce, virtually eliminating that threat,
according to Montier.
Meanwhile, Bernstein agreed with Montier about the likely direction of Fed policy but said
that investors don’t have to be overly conservative.
Fed policies have created a distaste for certain asset classes among investors, Bernstein
said, based on a mistaken belief that they won’t do well over the next five or seven years.
He said the key is to find asset classes rejected by other investors, where investors can be
the equivalent of a “single banker in a town of 1,000 borrowers.”

The opportunity in bonds
One such opportunity is Treasury bonds, which Bernstein said serve as an effective
diversifier to equities. Treasury bonds have been negatively correlated to equities in the
recent past, he said, and they can reduce the risk associated with an allocation to equities.
“Treasury bonds have been a tremendous risk reduction tool the last five to seven years
and worked very consistently,” he said. “But yet, people hate Treasury bonds.”
Montier, however, said bonds are “doomed to give you a low return no matter what
happens.” If the Fed continues its monetary easing, bonds will offer negative real returns. If
the Fed tightens, rates will rise and produce the same outcome. Only in a deflationary
scenario would bonds offer attractive real returns, he said.
Investors shouldn’t overrate the diversifying value of bonds, according to Montier. When
measured over a time horizon of longer than seven years, Treasury bonds have actually
been positively correlated to equities, he said.
But Montier said investors should not be forced into a conservative allocation simply
because they fear the Fed’s actions. “In every cycle there is a period of time where there is
uncertainty about a change in Fed policy, and whether fundamentals will be strong enough
to offset the negative effects of rising rates,” he said. “In this cycle it is no different,
although it is a bigger issue because the Fed is more involved.”
One reason to hold bonds is that rates may continue to fall. Bernstein said the Fed is
“always late” and will again be extremely late when it does tighten its policies,
“By the time the Fed actually does seriously start reversing course, people will wonder
what took them so long,” he said. “I do not think that is the environment that we are in right
now.”
The Fed spent the last three to four years supporting the economy, and investors should
not assume the central bank “is really that stupid” to let it fall apart, Bernstein said. “They
may not be the smartest guys in the world, but they are not that stupid.”
Is there value abroad?
GMO’s forecast for emerging market equities is a real return of 6.2% over the next seven
years, but Montier cautioned investors against embracing that asset class.
Montier said there is a view within GMO, championed by Edward Chancellor, which
challenges that forecast. Chancellor argues that the emerging market forecast is artificially
inflated by an optimistic view on China. According to Chancellor, China faces a real-estate
market bubble similar to that in the U.S. in the mid-2000s. The financing vehicles used in
China are incredibly similar to those used in the U.S., Montier said. He compared Chinese
financing vehicles with the collateralized mortgage obligations that blew up in the financial
crisis.
The attractiveness of any market rest on two factors, Montier said: the scale of the
opportunity (6.2% real returns) and the confidence in that forecast. “What Edward’s work
does is question the fundamental assumptions made in that model, and that worries
everyone,” he said.
Bernstein agreed that emerging markets are unattractive, particularly compared to U.S.
equities.
Emerging markets have an inflation problem, Bernstein said, with India having the highest
rate in the world, excluding frontier markets. Indeed, the rioting in Turkey and much of the
unrest related to the Arab Spring was due to high inflation, according to Bernstein.
“Everybody believes there is a story about the emerging market consumer, but yet the
purchasing power of that consumer is being eroded like there’s no tomorrow,” he said.
“Nobody seems to care about that, but everyone is worried about inflation here in the
United States. That is why people’s expectations for the U.S. are way too low about the
fundamentals, and they are way too optimistic in their opinion of emerging markets.”
Bernstein said the rate of negative earnings surprises has been between 55% and 60% for
emerging markets over the last several years, compared to about 25% for U.S. companies.
Monetary inflation fundamentals are eroding rather significantly in emerging markets, he
said, and growth prospects are not what everybody thought they were.
Neither Montier nor Bernstein recommended European stocks. Montier said some sectors
in Europe are cheap, but they are “almost indistinguishable from junk,” in that those
companies’ debt levels are too high to offer value. There is an “unhedgeable risk” risk in
those companies, he said, because if a country were to leave the EU, a company
domiciled in it would have debt in a currency not its own.
Bernstein said that he wouldn’t be bullish on Europe until sufficient political pressure is
placed on Germany to rebalance the European economy

Investing advice from Winnie the Pooh
“The best hope investors have is that the pendulum will swing,” Montier said. When assets
are priced for perfection – as they are now, he said – investors will get a “repricing” that will
allow them to take advance of shifts in the opportunity set.
“Right now, you do not want to be fully invested,” Montier said. “You need to have
something with cash that will allow you not only to worry about today’s constrained
opportunities set but also take advantage of tomorrow’s opportunities, three months’ or two
years’, which may be considerably more effective.”
Bernstein, however, is bullish on U.S. equities. In a commentary published earlier this
month, he wrote, “The standard warning signals of a bull market’s end seem nowhere in
sight in the U.S. The Fed isn’t close to tightening too much, investors’ constant uncertainty
and lack of confidence regarding the stock market suggests attractive risk premiums and
good value, and there is hardly euphoria for U.S. equities.”
But Montier recommended a conservative approach, taken from a children’s book.
“The best way of beating the low-rate low-inflation environment is altering your asset mix
over time,” he said. “In the immortal words of Winnie the Pooh, ‘Never underestimate the
value of doing nothing.’”