GMO Quarterly Letter

And the Winner Was…T-Bills?

A down year makes for much-improved opportunities

Ben Inker

Executive Summary
2018 was a lousy year for almost all assets, with no major asset class around the world able to keep pace with U.S. Treasury Bills. The poor returns were not driven by any economic calamity, but by markets coming into the year with unrealistic and incompatible expectations, which wound up being generally disappointed. The poor returns have a silver lining, however, in that today a number of asset classes are priced at levels that embody much more achievable expectations and decent longterm returns. In general, it looks to be the best opportunity set we have seen since 2009. This means it is reasonably straightforward to put together a diversified portfolio priced to achieve something close to +5% real return. But as U.S. equities and nominal government bonds are not among the appealing assets, we believe the portfolio you should own today looks more or less nothing like a traditional 60% stock/40% bond portfolio.

Your portfolio likely lost money last year. It wasn’t in a catastrophic, 2008 kind of way, but I am reasonably confident in saying that for U.S. dollar based investors reading this, 2018 ended up with a negative sign before your total return. The strong U.S. dollar meant that non-U.S. investors owning unhedged foreign assets did a little better than their U.S. counterparts, but only in places like Australia and Canada, where local currencies were very weak, would many investors have had a shot at achieving positive total returns. Of the asset classes that traditionally have meaningful allocations in institutional portfolios, only the Bloomberg Barclays U.S. Aggregate Bond Index (Agg), a proxy for investment grade bonds, gave a positive return in U.S. dollars – and it earned a princely +0.01%. Otherwise, pretty much everything was down. The S&P 500 fell 4.4%, soundly trouncing both MSCI EAFE (down 13.8%) and MSCI Emerging (down 14.6%). Real estate proved no hedge, with REITs falling 4.6%, and small caps were even worse than large caps, with the Russell 2000 down 11% and MSCI EAFE Small Cap down 17.9%. Credit was no haven either, with the Bloomberg Barclays U.S. Corporate High Yield down 2.1% and the J.P. Morgan EMBI Global emerging debt index down 4.6%. The best performing major asset worldwide was stodgy old U.S. Treasury Bills, up 1.9%. It was the first time since 1994 that T-Bills beat both the S&P 500 and the Agg, and the first time since 1981 that they outperformed those assets along with non-U.S. equities, small caps, and REITs. It is worth pointing out that in 1981, T-Bills returned over 15%, so an index could trail it and still deliver a double-digit return. As a result, 2018 arguably set a new standard for universal dismalness.

For all that, a 60% stock/40% bond portfolio1 lost only 5.5% for the year, a far cry from the 26% loss such a portfolio suffered in 2008. In reality, it was merely the fifth worst year in the past 30, hardly an outlier in a total return sense. What feels so odd about 2018 was the sheer unavoidability of the losses. In 2008 you could at least daydream about having had the foresight to move your portfolio to government bonds and reap a +12.4% return. There was no such haven asset in 2018.2 Had you had perfect foresight about asset class returns for the year, the best your long-only portfolio could have achieved was +1.86%, earned by investing your entire portfolio in 3 month Treasury Bills.

The other interesting feature of the year was the fact that the broad swath of losses across asset classes was not driven by any particularly horrible economic events. According to the IMF World Economic Outlook report, real GDP growth for the 12 months ended June 2018 (the most recent data I could find) was +3.2% U.S. dollar weighted and +3.7% purchasing power parity weighted. These were the best growth rates since 2010 and 2011, respectively. World inflation, while up 0.6% from 2017 at +3.8%, was below the average level since 2000. And yet, more or less every asset capable of delivering a capital loss did so.