March 29, 2011
Analysts have forecast that profit margins are going to get to a level never seen before in history, Inker said. One reason is that capacity utilization in the economy is very low, and when it has been low in the past margins have expanded.
Inker doesn’t believe increased utilization will drive profits higher in this environment. Profits are defined in economic terms as the sum of net investments and dividends, less savings by the rest of the economy. The latter two terms tend to be fairly stable over time, and changes in net investments are what have caused profits to rise and fall, he said.
In the last 20 years, though, higher profits have been more a result of the government running a 9% deficit, Inker said, than of higher investment. Inker said that from 1952-1986 profits and capacity utilization had a positive correlation of 0.57; since 1987, however, that correlation was -0.17.
Even if net investment were to triple – which Inker said isn’t actually that hard to do – and if the government went to a “sustainable level of deficits, there just isn’t enough money out there for corporations.”
Bonds offer disappointing prospects for other reasons. Government yields are now at 60-year lows, Inker said. The last time yields were this low was in the 1940s, and bonds then were a “spectacularly bad investment for length of time longer than most professional careers,” he said. Indeed, for the next 40 years, bond investors suffered worse returns than cash investors.
Portfolio construction
GMO constructs portfolios for its clients in two distinct ways. Some clients give it a benchmark and charge GMO with outperforming it. In those cases, Inker said, it is “hard to be excited” about owning stocks, and yet he said they were only 4% underweight in equities.
A quarter of those equities are in high-quality companies, which Inker defined as firms with high and stable profitability across the economic cycle, as well as low debt. Inker said emerging markets are the next favorite piece, and that GMO has been buying Japanese stocks in the last month.
Within fixed income, Inker said there are few traditional government bonds that are worth owning. Most of GMO’s holdings are in “dry powder,” Inker said, which are assets that will not be impacted if rates go up or the stock market goes down.
In all, these benchmark-based portfolios have about 23% of their money on the sidelines, and Inker expects them to return 4.1% annually after inflation, which is better than their benchmark but not acceptable for their clients.
For other clients, GMO has an absolute return mandate that is not tied to a market benchmark. In those cases, Inker said, it makes a lot less sense to own equities, and GMO has reduced its exposure more aggressively, to approximately 41%.
Unlike the benchmark-based portfolios, those portfolios own a number of hedge-fund like strategies, including 15.1% in “alpha only” and 20% in “multi-strategy” categories. Approximately 18% is held in fixed income.
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