James Montier on Fed-Induced Bubbles, Market Valuations, Smart Beta and Liquid Alts
James Montier is a member of Grantham Mayo van Otterloo’s (GMO’s) Asset Allocation team. Prior to joining GMO in 2009, he was co-head of Global Strategy at Société Générale. Mr. Montier is the author of several books including Behavioral Investing: A Practitioner’s Guide to Applying Behavioral Finance; Value Investing: Tools and Techniques for Intelligent Investment; and The Little Book of Behavioral Investing. Mr. Montier is a visiting fellow at the University of Durham and a fellow of the Royal Society of Arts. He holds a B.A. in Economics from Portsmouth University and an M.Sc. in Economics from Warwick University.
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I spoke with James on January 15.
You wrote two papers in the past year (The Idolatry of Interest Rates Part I: Chasing Will-o’-the-Wisp and The Idolatry of Interest Rates Part II: Financial Heresy) on a world without a natural interest rate, The Idolatry of Interest Rates. If interest rates were not being administered by central banks, at what level do you think the market would be setting them?
That’s a fascinating question to which I genuinely do not know the answer. The reason is that interest rates have pretty much always been an administered price. It has always been central banks or governments at least that have set interest rates, at least a benchmark rate. Without that foundation rate, it would be an interesting problem for the financial markets to try and solve. But I don’t think there’s a natural rate that could be divined that everyone would be obliged to respect.
There has always been an interest rate set by the government and/or the central bank. For much of history it was basically the governments, and obviously more recently it has been the central banks.
Without somebody setting at least a rate, I don’t know what markets would price since everybody seems to think of interest rates in the corporate markets as a spread of the government. It is not obvious to me what rate it would be.
Given that administered interest rates are in effect, they are really fixing the price of the cost of capital. Price fixing of other assets historically resulted in market distortions. What, if any, distortions do you perceive, and when and how do you think they might be resolved?
When I look at the world today, pretty much every financial asset has been impacted by the administered rates. Effectively, what has happened is the central banks have been behaving in a way that William McChesney Martin would’ve hated. He was the longest serving Federal Reserve governor of all time, and his famous saying was that the central bank’s job was to “take the punch bowl away just when the party was getting interesting.”
But we’ve had central bank governors – Greenspan, Bernanke and Yellen – who are more like teenagers at a prom night. They are spiking the punch bowl and handing out free drinks and hoping to get lucky at the end of the night.
They have engendered an enormous amount of risk-taking, and you can see that in the fixed income markets and the well-known indices. You can see it in equity markets. When we look at equity markets, we see them to be significantly more expensive than we would like to see in terms of the concept of a fair return to equity. Pretty much every financial asset has been a victim of the way in which these administered prices have been set.
Let me ask you about the role of the Internet in commerce. I want to suggest that it’s not the first network that has been inherently deflationary; the telegraph and railroads are other examples from the past that helped drive down costs and prices. What do you think about the Internet and the impact that it has had on interest rates, profit margins or reversion to the mean?
There was a book written during the tech bubble and then released just after by a chap called Alasdair Naim. It’s called the Engines That Move Markets. It was a history of technological revolutions over time and how they played out. It was fascinating in as much as every single one of them you could argue was essentially deflationary in some regard – sometimes in a very specific narrow sector, sometimes in a much broader context. But one of the intriguing patterns that struck me when I read that book was that all of the benefits that these new technologies brought ultimately always accrued to the consumers, not to the producers. But people always got massively over-excited about the producer side – “This new technology was the new hope.” It didn’t matter whether it was railroads or telegraph or the Internet. There’s always been this insane mania-like thing associated with these big technological innovations because people have always thought they were going to capture the profits.
Invariably they didn’t. They end up transferring the surplus to the consumer and benefiting the consumer through the engine of lower prices. In many ways this downward pressure on prices is also the kind of good deflation, if you will. It is not the evil lack-of-demand-driven deflation that we usually associate with the word, the 1930s terrible experience with everybody out of work and nobody having any money to spend. That is a really bad deflation. This is a gentle downward pressure on prices brought about by competition, and it’s actually to the consumer’s benefit, and therefore, pretty good.
In terms of the three issues you mentioned, I don’t think it’s had a huge impact on rates. Rates have been set with a mind to things other than perhaps the kind of deflation. Central banks are much more worried about the lack of growth in the economy generally than the general downward pressure of prices. Let’s not forget that, on average, prices are still rising, just not as fast as they used to. The Internet is just part of that general process. It is depressing prices in some areas. But areas where prices are still rising, for example, school fees, always spring to mind. I don’t think the Internet had a huge impact on rates.