Grantham and Dalio: The Equity Bubble is Bursting and Stagflation Awaits
Two of the world’s most respected investors, GMO’s Jeremy Grantham and Bridgewater’s Ray Dalio, offered identical warnings: The bubble in U.S. equities is unwinding, and the economy is headed for stagflation.
The two spoke in a virtual panel discussion earlier this month. They were interviewed by Jim Haskel of Bridgewater and Alex Shahidi, who is a managing partner and co-chief investment officer at Evoke Advisors, a Los Angeles-based asset manager, as part of its master speaker series.
Grantham is the co-founder and long-term investment strategist of Grantham, Mayo, & van Otterloo (GMO), a Boston-based asset management firm. Dalio is the co-chief investment officer of Connecticut-based Bridgewater Associates, the world’s largest hedge fund, which he founded in 1975.
The market is showing signs of breaking down, according to Grantham. He said this has been the worst opening of a year for the S&P since 1939, a year before he was born.
“This is the real McCoy,” Grantham said, and market dynamics are playing out close to the way they did in 2000, when the dot-com bubble burst.
He said this was one of the “great bubbles,” which are characterized by hysterical behavior and accelerated price moves on the upside. As it unwinds, investors are shifting to blue-chip stocks, which are going up, but risky growth stocks are going down. This phenomenon is unusual, he said, but it happened in 2000. Grantham called it a “very rare indicator of impending doom.”
That behavior is a “pretty good indicator” of what happened as the housing market started to decline in 2007, Grantham said. It reminded him of Russ Prince, then the CEO of Citibank, who said that investors “have to keep dancing while music is playing.”
But investors are not idiots, Grantham said, which is why they are moving to safer stocks. “That works,” he said, “to a degree, as the bubble breaks.”
“We’re in it, dudes,” Grantham said. “Declines will be very substantial.”
Dalio commented on the macroeconomic outlook and said that this is the third year of expansion with aggressive monetary policy, which is causing inflation. Money and debt have been created to such a degree that there must be a decline in real wealth. Everyone believes that financial assets will pay for their goods and services, he said, but there will be negative real returns instead.
Like all bubbles and paradigm shifts, he said, investors have not been worried about inflation and believed that cash is safe.
“This is a punch in the face to all investors,” Dalio said. It is one of the rare scenarios when good technology companies “get hammered.”
The 2022 elections will have a big impact on economics and markets, according to Dalio, and there will be greater extremism and populists will prevail. He is also worried about the 2024 elections, fearing that neither side will accept losing. “When the causes are more important than the systems,” Dalio said, “the systems are in jeopardy.” Both the U.S. and Europe are in that situation.
We are in a period in which the supply and demand for debt and credit are making stagflation likely, Dalio said, like the 1970s. But political influences are more important. We have been used to an environment where economics ruled, and the most efficient countries got the business and that raised their standard of living. That doesn’t exist anymore, Dalio said, as manufacturing will gravitate to countries that are more ideologically aligned with the U.S.
Elon Musk’s acquisition of Twitter was not motivated by financial concerns, he said, and same is true of Disney’s LGBTQ policies that brought the reaction from Florida Governor Rick DeSantis.
Grantham said the market will phase into the stagflation of the 1970s. The deflationary effects on the stock market and economy will mean “all assets will be lower priced,” he said.
“The Ukrainian war, COVID and monetary policy guarantee that we will have a short-term, intractable problem,” Grantham said.
In the long term, Grantham said, “we are running out of people.” China has been running out of working-age people for the last 20 years. It will have a shortage of labor, he said, as will the developed world. In the U.S., we are having fewer children for the first time since 1961. The degree and speed by which fertility rates are decreasing is not appreciated by the financial world, according to Grantham.
“We are entering a period of scarce labor and scarce resources,” Grantham said, “which is inflationary.”
Grantham said that GMO tracks an equally weighted index of 36 commodities, and it declined secularly from 1900 to 2002; it went down 70% to an index value of 30. Today it is back to 90, which means the average commodity tripled in the last 30 years (mostly, he said, because of China). “This represents intrinsic scarcity,” Grantham said, of key resources such as oil and iron ore. It has been a struggle between technology and scarcity, he said, and “the data is screaming that we are running out of resources.”
The same applies to food, according to Grantham. The UN food index is at its highest level in the last 50 years.
“We are so fragile that if you cough, it ricochets around the world in price shocks and bottlenecks,” Grantham said.
With the price pressure on raw materials and labor, he said, “this is a new era where inflation will be part of the background music.”
Grantham’s concerns were not limited to resources. “The risks of an equity or debt bubble breaking are not understood by the Fed,” he said. “They don’t realize that they are playing with such fire.” High levels of debt are too dangerous and should be discouraged by corporations and the Fed.
Since 1985, the total U.S. debt-to-GDP ratio has tripled, from approximately 1.1 to 3. Growth slowed, Grantham said, but there is little room for the idea that more debt creates more growth. “It is not proven by the data. Debt has nothing to do with growth, just higher risk.”
To invest in this era, Dalio said to avoid debt and claims against financial assets. Position yourself for inflation, he said. He agreed with Grantham about commodities, but the overarching issue is that, as financial claims relative to real assets grow, it leads to an environment where you don’t want to own debt.
You can reduce risk and raise returns by positioning for rising inflation and slower growth, according to Dalio. He said to look at countries with good financial stability and solid balance sheets, and that are civil with each other. Internal conflict and bad finances will be a defining characteristic of where to be, and said he likes emerging Asia and India.
Grantham advocated investing in resources in an inflationary environment. They are modestly negatively correlated with the rest of the portfolio over the long term, he said. “There is a very strong case for a resource portfolio.”
Robert Huebscher is the founder and CEO of Advisor Perspectives.