Home>Video>Grantham Keynote: Investing in a Slower-Growth World

Grantham Keynote: Investing in a Slower-Growth World

Fri, 22 Jun 2012

The GMO chief strategist highlights the factors behind the market's bullish bias, abnormally high corporate earnings, current valuation levels, a slowdown in productivity, and the great paradigm shift in natural resources.


Video Transcript

Scott Burns: We are all here, so bright and shiny, and it’s early. We must be really excited about our first speaker. I think that goes without saying.

So we've got Jeremy Grantham here. I think Jeremy Grantham gets typecast a lot as a bear, rather unfairly, because a bear is just hunkered down and holding cash, and not buying anything. But Jeremy has been investing in quite a few things over the years. He's just been a little bearish on U.S. equities, and if you are a bear, I guess even if we do want to wear that typecast label, I guess it's OK to be a bear when you're right as often as Jeremy is, right?

So Jeremy and I talked about education quite a bit. We’ve had so many people in the back, while we were getting ready, come up to Jeremy and thank him for his quarterly insights and the education role that he's played in helping investors understand what's happening in the markets, what's happening in their own investment behavior, what's happening with valuations. And so it's with great pleasure that I introduce GMO's Jeremy Grantham.

Jeremy Grantham: Thank you, nice to be here.

I suppose I should start by saying that I don't feel I really do know much about what is going on right now. It's a very strange time, and I get this Groundhog Day effect, as if the news is just replaying and replaying.

I just visited, a year later, the other day, a client, and I read my notes of the year before, and holy cow, nothing has changed at all. Greece was about to collapse, no it wasn't. Bernanke was thinking about QE 23, and China for two years, according to several of my very smart colleagues, was about to stumble big time into kind of zero growth, and it still looks like that today, that it might. It still claims to be growing at 8%, but it looks like it might be stumbling big time. And people have a wonderful story: look at the electric output and so on. And Bernanke still identically talking the same game, and the EU just goes round and round in torturous circles, and the market just goes up and down, going nowhere in particular. I actually think that the Financial Times is recycling its old articles. They seem so desperately familiar and, of course, by definition, incredibly boring.

I've got three things to talk about, but I wanted to just share, first of all, kind of Friday morning thoughts. In general, everybody is automatically a little optimistic. If given half a chance, people will assume things will work out. I believe it's programmed into our species. I think back in the days when we were hanging on by our fingernails, if you were a pessimist, you just gave up.

So, we're the survivors, we're the optimists. And I think it's evident when you look at the history of the stock market. Give it half a chance, and it will spin a terrific story. And it will always be reinforced by the financial industry. The financial industry has a huge investment in being bullish, and being bearish is bad for business, and therefore, nobody in round numbers ever is. So, that's kind of theme one. Be prepared to see a bullish bias in normal situations.

Secondly, quite separately, people like to stay in the pack, and sometimes the pack wants to go hurtling downwards, so you can have bear markets OK. You have a bullish bias, and then quite separately, a bias to create a herding effect, driving stocks or markets, commodities, everything up and down, far away from anything sensible, but still with an overall bullish bias.

Another breakfast thought is that the earnings level is abnormally high. And GMO is pretty academic, sometimes to its cost, and so we ruthlessly normalize earnings to very long-term averages. And that's what separates us from most of the data. People think the American market is very cheap, in general. A great majority think it's reasonably cheap, and we don't, because we want it to be priced to the normal earnings. And the bulls say, well, of course, there's been a paradigm shift. Profit margins are higher and always will be higher, because that's what bulls like to say. And we say, other things being equal, we'll always bet on the average--profit margins will come down.

And think how weird profit margins are. We have high unemployment. We have lots of things going wrong. We have, I think, a justifiably scary world, and yet we have world-record profit margins. It is truly weird. It has never occurred before.

According to my colleague, Ben Inker, and some economists over the years, there is a relationship between rising government debt and profit margins. As government debt rises, other things being equal, underlined three times, profit margins tend to go up. And when they start to pay down the debt, other things being even, profit margins come down, and that seems pretty plausible in today's situation, but it gives you this artifact, and it's a prop to the market: world-record earnings. And they are believed by most people, but not GMO. And so they look at the P/E on these astronomical earnings, and they say, oh boy, the market is really cheap, so that even though I'm nervous, I don't necessarily have to sell my stocks at such a bargain price. And, in fact, American stocks are a little expensive, and as earnings turn over, which they are doing now, I was worrying over breakfast that people would see that, oh my, earnings are not what we thought they were. And that would give a nervous marketplace a pretty good excuse to come down. So it's kind of offsetting errors. The market wants to be nervous, thinks it's being nervous, and thinks it's priced the market accordingly, but only because it quite incorrectly gives full credit to today's earnings. So I think that is food for thought.


Three topics--and the first one is, my sister's pension fund, on which I wrote a quarterly letter very recently. Just to remind us what dominates our industry is career risk--keep your job, and Keynes explained how you keep your job in 1936, General Theory Chapter 12, a must-read, and he said, you do that by making sure you're never, ever wrong on your own. You can be right on your own, and even that's a little suspicious in the eyes of the world. They pat you on the head when you are in the room, but when you leave the room, they describe you as a dangerous eccentric. If you are wrong on your own, they don't bother to describe you as anything, they just fire you. And if you want to avoid that, said Keynes, you look around and see what everyone else is doing, do the same, and if you want to win, which everyone does, try and be a little quicker and slicker on the draw. Execute the strategy better than they do. And so you have to anticipate what the world will do, and if you are very smart, you anticipate what other people anticipate the world will do.

And [Keynes] was right. He was 80-plus years ahead of the rest of the world, because the rest of the economic world still hasn’t caught up. And in between, they went into this nonsense about market efficiency. But Keynes made a fortune and blew it a couple of times, and he is one of us; he really knew that the market is a kind of creature, and animal spirits is critical, and he reintroduced animal spirits into economics. But he knew that the desire not to be wrong on your own created enormous momentum, and it drove the price of everything away from fair value. It dominates our industry and how we behave.

There is no big company, public company, that could make a big stand against a major equity bubble like 2000. If 2000 happened again in 2019, no big public company will tell you that it's happening. Because if you get your timing wrong, you'll lose too much business, and you get fired, and you can't take that on your quarterly earnings. So, you go with the flow, it's a much safer strategy.

Keynes described a row of bankers marching of the cliff together. He said as long as they make sure they're all together, their careers are reasonably safe. That's a pretty good description of '08. If you wanted to lose your job, you had to do something spectacularly incompetent. Otherwise, you're in decent shape.

But coming back to the market and this exhibit, there is--thank heavens for all the value managers in the world--there is an underlying reality, which has a huge pull. Sooner or later, things will trade at replacement cost. If you can't build a polyethylene plant because the prices are too low, you stop building, everybody stops building, years go by, there is a shortage, the price starts to rise, and eventually you sharpen your pencil, you can build a new plant, and make a profit, and you do, and the cycle turns.

Conversely, if you can build a plant and sell it in the stock market, as it were, for three times the price, like you could for fiberoptic cable, then you'll build about 30-years supply, as long as the market supports it, and you'll glut the market for years, which is what happened.

So replacement cost is a huge pull, but sometimes the cycle is very slow and sometimes the cycle is very fast. When it's fast, that's fine; value managers make a lot of money. But when it's slow, once it goes over three years, the clients' patience begins to run out, and they shoot you. And that career risk is the dominant risk in our business. What it means is that big asset classes will always be horribly inefficient because arbitraging them is dangerous for your business health.

I always like to say, if you're an insurance analyst, it's very hard to get fired. You pick a few insurance stocks, it takes a few years to see if you have any talent, and by the time it's revealed that you don't, the research director has been fired a couple of times, and they've forgotten, and so you can go on indefinitely. But when you get into the business of picking insurance companies against oil stocks, then everything is revealed, and at the top of the line, when you pick cash against stocks because you're nervous, then your life expectancy when you're wrong shrinks down to a year or maybe 18 months, if you're lucky.

This is why my sister's pension fund is such a good example, because here's a situation where I have no career risk. She's never going to fire me. She doesn't even know what her performance is like, because I don't tell her. I tried that. I think you may have read it in my letter, and whatever I said to her, she said, sell, sell! So I quit. If it was going up or down, she wanted to sell. And I've managed her money since 1968, and I'm her brother, she's not going to fire me. So, I can do everything I absolutely want.

And it turns out the biggest career risk is getting out of a major bull market. It's not on the bear side. You think in a rational world that how you do in a bear market is the most important thing. It's not true. I'll tell you why. Particularly in the institutional world, the clients become paralyzed, catatonic, in a really major decline like '09, or 1974, or '82, and they lose the ability to focus on the details, and a minus 51% and a minus 43% look the same, even though it might take a rally of 14% to close the gap. And they say, oh my god, everyone is rolling in red ink, I'll wait until the smoke clears, and then work out what to do.

But on the upside, they're jumping with energy, they're fueled by CNBC, at lunch time they are not watching basketball replays, but they're looking for the new Internet stocks. They know the performance of every manager. They are listening to the hedge fund guys on the committee, and they see that everybody is averaging 30%, and there are these clowns down there at 21%. And the hired gun, being in fact more sensible, will say, yes, but these guys have a lower risk, and they didn't do at all badly the last time the market went down, but no one wants to hear that story. They're into the moment, they want to swing, and they're exchanging stories on the golf course with their buddies, and they're feeling quite dreary and second rate, and so they fire the people who are left behind. This is a much more powerful move than anything on the downside.

And I keep telling the story because it's a good story, that in the 2000 bubble, we'd been screaming for 2 1/2 years by the peak that the market was irrationally overpriced, and then finally dangerously, dangerously overpriced. And the clients were so fed up with us that in one famous case, famous to me, they banned me from the building in Manhattan, because I was, "dangerously persuasive and totally wrong." And of course, we were totally right. We made the right bets for the right reasons, and we won them very handsomely. We lowered the risk, and we increased the return, but we lost more business than anyone else on the planet, and in the asset allocation group, we lost 60%.

It's an absolutely perfect case of what Keynes was talking about, and it's a perfect case of what I'm talking about, and that is that the biggest of all risks is on the upside and not the downside. If you can just get out of the major bull markets, keep a cool head, spend some career risk units, that is the biggest contribution you will ever do for your clients. And when your timing is not perfect--and it will not be perfect--you must expect that they will take it personally, because they are concentrated, they are excited, and they take little deviations very much to heart.

At this rate we will take three days to get through my exhibits.

This is allocation--principles you need to know. Mean reversion drives everything. Everything is always going to go back to normal, with one exception that we'll get to. Markets are shockingly inefficient, of course. Wait for the fat pitch. Don't tickle the market to death. Wait and wait and wait and wait, and then hit it. One of my sister's pension fund's advantage is that I don't over-manage it. She is lucky if I do it twice a year, or once a year is more normal.

Everyone in this room and everyone in the institutional world, we all over-manage money. We over-manage money for very good career risk reasons: We want to be seen busy. We want to be seen to be earning our keep. But you don’t make money by rushing around making a trade every day. You should let it mature, let things happen, and then hit it pretty hard.

I’m very proud to say that I've been for 24 years on the Committee of the Massachusetts Society of Prevention of Cruelty to Children. It's been my only outside investment account most of the time. And 10 years ending March 31, we're in first place with our miserable $30 million. But we meet four times a year for an hour and half, and we are ahead of Yale and Harvard. Yes! And it is an absolute testimonial to the fact that four times a year is more than enough.

Now my sister’s pension fund--by the way, the legal beagles don’t allow me to say "pension fund," [but] my sister’s pension "strategy," otherwise you will think we have a fund at GMO called "my sister’s pension fund," okay. My sister and I only meet once a year, and so we do slightly better than that. Once a year is great, but the client will fire you, so you have to manage that problem.

Benchmark risk is not enough. Protect capital. This is much more an institutional thing than a retail thing, but you can sit down with a great, sexy Dutch pension fund dripping with Ph.Ds, and you have lunch and you talk about risk 12 times, and each of the 12 times they did not mean the risk of the beneficiary, the pensioner losing money. They meant the risk of deviating from their precious benchmark and putting them into some career risk with their bosses. And nobody thinks of risk as the actual real risk to the beneficiary. It's actually almost unethical. Effective implementation, that always helps.

This is how we do our seven-year forecast. We used to do 10-year forecasts. The top row is very important. It's what is normal--what do people think they get at fair price? It's the only thing we've done that everyone always agrees with. 5.7% on the left for blue chips, real--every number from GMO is always after inflation adjustment. You get a little bit more for small cap and emerging for taking risk, and in the red on the right, you get quite a bit less for bonds, but nothing like the huge gap that you used to have in history.

On the second row, if we got there tomorrow, as of ... May 31, that's what would happen. You'd lose a ton in U.S. small cap. But international large, small and emerging are fair priced, right on the nose. And on the bottom row, what would happen if you amortize that smoothly over seven years?

So today, we think you could put together a portfolio, a respectable portfolio, of international stocks. If you tilt to value, it's dangerous, but you do a lot better on our seven-year forecast. If you can ride out any problems that may come along in the next year or two, you should do better. You are being paid for it, particularly in European value, which is not surprising.

In the U.S., however, we would only buy growth stocks. Here's our official forecast, as of May 31, and you can see, U.S. high quality stocks are 4.8%. For high-quality portfolios, the AAA of the equity market, 4.8% is not that bad. And in any case, it nicely balances the extra risk of emerging at 6.7%. I'm not saying there aren't a lot of short-term risks in emerging. China very well may stumble, some of these things may do badly in the near term. But usually if you take a seven-year forecast, things will work out pretty well, and things recover and move back to normal.

So you can do a pretty decently diversified equity portfolio at about the normal returns that you would expect. Just, by the way, yesterday's move down of 2% adds 30 basis points to the seven-year forecast every year to recapture it.

Over on the right you see usually my favorite asset class, timber, 6.5% real. But the real problem is in red, bonds are disgusting. Bernanke, and before him Greenspan, have artificially depressed the real rate structure. They do it to encourage you to get so fed up with parking your money at minus 1%, that you'll move it into the equity market. The longer they do it, the more seductive it becomes. So gradually, unless you're really strong willed, you find yourself edging over to the stock market, don't you. We do. And we have to fight it. It makes it so expensive to have the dry powder that you know you should have in the face of the euro, China, and the debt overhang, which is a pretty big problem.

So, to get back to career risk, if you go to a consultant, they will tell you, in September '07, at the peak of the market, that instead of having 5.7% real return, they have lowered their equity estimate to 5.2%. I'm not kidding you; that's exactly what they do. And at the market low, they'll take it up to 6.3%, because they're not in the business of taking a lot of career risk, and I sympathize with them completely.

But our forecast, and it was public record, this is what we said in September '07: We said U.S. High Quality, bless them, plus 2.2 everything else negative, a real disaster area waiting to happen. And a few months later, in March of '09, we had these magnificent numbers, and these were not the high. We say on the left, 8.9 real in the S&P in, sorry, February '09, but they got lower the first two weeks of March, it went through 10%. In the middle of March, it was 10% real. I had the incredible good fortune to post my only non-quarterly letter, which was called "Reinvesting When Terrified," which Tucker Hewes, our PR guy, helped me inadvertently post on the day the market hit the low, and it said, of course you're terrified, everyone is terrified, and you won't catch the low and it may go much lower, but that's not your business. Your business is to look at the values and to say these are the cheapest prices for 20 years. You've got to get a battle plan, you've got to get your wits together, your courage together, and start to get your money back into the market. And things were moving so fast that two weeks later the 10% had gone to 8.9%. U.S. High Quality 12.7%, and small-cap international 12.7%. Emerging markets had been over 12% in the previous November, it collapsed in '07. And that's a pretty good range, and that kind of range comes with a lot of career risk, and that's where we are today. And you can see how boring that is in comparison. Equities are boring. Bonds are disgusting. It's a difficult environment to operate in, and the outside world is scary.

On the left-hand side here, we have our flagship allocation account, Global Asset Allocation, and on the right, we have my sister's pension fund equivalent, which we call "Benchmark-Free." It has, when poked and prodded, it has a little career risk I think showing, but not much. And this is the point of maximum stress, when you really, really wanted to be conservative. And on the left, we have a rock-bottom minimum allowable equity position of 45%, and that was pretty close, 46%. On the right, we could theoretically go to zero and we were 25%, but let me point out that all 25 points were in GMO's Quality fund. The Quality Fund, super-blue chips like Procter & Gamble, only went down 0.6 times the speed of the market, so we had the equivalent of 15% or 16% in the equities. I think you might agree that's about as close as you're going to get to a sister's pension fund. I'm proud to say my sister's pension fund was slightly negative. So there was a gap, but not a big gap. But in anything approaching a normal account--and the Global Asset Allocation is our attempt to look normal and save as much money as we can, to avoid getting fired.

The new portfolio that we offer through Wells Fargo, I suppose if you were cynical you could say, is an invitation to get fired one day, because we got fired on the left-hand side portfolio in 2000, protected as we were by a minimum equity requirement, and this one would have been fired even more, and we try and guard against that by explaining this problem like mad, as I'm doing now, by having hit the ball out of the ballpark in the 2000 crisis,in 2008 we nailed those suckers, and generally trying to make the point clear that this is the way to make money if you can only find a way of controlling your own career risk, about which I have no easy answer.

Here is the benchmark in black since we started the global balanced, and you see the dotted line on the left, and the headline, "Is This Relative Risk or Absolute Risk?" On the left hand side, in the first three years we went out 51%, far more than the client’s budget. But the benchmark went up 83%, and Fred somewhere out there was up 101%, and that comparison was too painful, and they shot us. They shot us for going up above budget, but less than the benchmark. A classic example. And then on the way down, we didn’t actually go down in 2001 and '02 in this mutual fund. By the end of the day, in the bottom right-hand corner, it gives you an efficiency measure, and that is the volatility, how much it bounces around per unit of return, and the benchmark gives you 28 bps of return for every point of volatility, and our fund doubled it. We're twice as efficient. For every unit of risk, we deliver twice the return for 15 years. And yet, as I've said, this was the account that got fired. And Sister's Pension Fund in red, the Sharpe ratio or the efficiency ratio, bottom right hand corner, instead of 0.65 of the Global Balanced Fund,  is 1.14.

Now this had the gloriously good sense to start in '01. Now if you're going to have a risky account like that, you better start it in '01. If you started it in '07, it wouldn't exist, OK. So, just so you know, in the interest of full disclosure. And that's what this fund did in the great down year of '08. It lost some money, shame. My sister didn't lose any money. It lost 12 points. But look at the hedge fund next to it. The very next column in blue, minus 22 was the hedge fund index. They can go short; ours is a long-only fund.

Hedge funds are disappointingly correlated to the market, are they not? I certainly own a lot, and I was shocked in '08. I worked out in advance very carefully what the beta of my hedge funds was, and I hedged them out. Being a bear, I hedged it all out in the futures market, and then the hedge funds went down twice as much as I had allocated.

So, lurking around with all this trivia like the end of the European world is a serious issue, and that is the only issue I ever scooped in my life a year ago, and that's resources running out.

It is going to play a very big role in everybody's life from now on, particularly in the poor countries, but we may be able to fake it for 20-30 years, but it will be constantly rising, erratic, volatile, rising prices, and rolling crises of availability that we have been seeing since 2002. And for whatever reason, we were the people who brought it to the world's attention.

In this exhibit, last April, we created 33 equal-weighted commodities and adjusted for inflation, and you can see that the typical commodity went down and down and down, except when there was a war, or perhaps even more importantly, the great oil crisis of '74, '78, '79. In between, though, it was trying to go down, and it went down a heck of a lot.

The average commodity declined over 100 years 70% in real price. What a help to getting rich that was. And then it gave it all back in 10 years without any fuss in the press or in the financial industry. It tripled. The price of grains, fertilizers, metals, energy, oil, coal--they all tripled, except natural gas in the U.S. Natural gas is a regional market. But what an amazing move. And a lot of people in '08, which is the first spike on the right, they said, oh, it's a speculative bubble. So let's examine that.

Price of oil goes to $155. Looked pretty dramatic. And then, in the financial crash, the whole world freezes, and oil goes to $35. Now that feels like a speculative bust. That feels like crushing the Internet stocks, or 1929. That's a huge decline, and it was very fast, but then what happened? Everything bounced back. The food index of the United Nations was higher last year than in '08. The price of oil measured in euros and sterling got back to its old high. Now that has never happened in the history of psychological equity bubbles, and we are the experts, we have all the data, 330 bubbles through the whole of history in all asset classes. There has never been a major crushing of any single asset class that immediately turned around and went back to the old high. Now this is more or less proof that this is in fact the great paradigm shift.

McKinsey jumped on my idea, and did a wonderful 120-page report with a different methodology, and the similarities, as you can see, are barely visible to the naked eye. They even used the same World War I and II oil chart as I had, but they did it in a completely different way, so it was very useful. They did it on a cap-weighted basis, with oil much more important. But again, 100 years of decline, 10 years going back to a new high.

So, we listed all the commodities, and we treated them as if they were stock market. In the stock market, we say that black line is the arbitrary bubble [cut-off], if you're 1 in 44 year event, it's a bubble, it's arbitrary, it's reasonable. Two and a half times in a century, you have bubbles. That seems about right. 1 in 44 is a nice bubble, 1 in a 100 is wonderful, 1 in 200, we've seen in Japan and Ben Bernanke's housing bubble. But iron ore is 1 in 2.2 million. Coal is 1 in 48,000. And corn, 1 in 14,000. We have never seen numbers like this in the stock market, and the stock market has bubbles like mad, so this must be something else. And what is it? It's the pressure of people. This is the population. Whenever you see a chart like this, you should jump nervously. When Malthus wrote his famous thing about population and starvation, they had 1 billion people. They now have 7 billion. It's tripled in my lifetime. In the good old days it doubled in a thousand years.

As you can imagine, you can't triple the population in a lifetime without consequences. We're on our way to 9 billion plus or minus 2 billion, and it's going to be extremely ugly. And the other thing, of course, is China. And this is a chart that we put together--why not--and it's really caused the biggest sensation, just letting people know what the facts were. And let me blow it up.

China used last year 53% of every bag of cement used on the planet. They used 48% of every ton of iron ore and 47% of every ton of coal. These are spectacular numbers. China has been growing at 10%. That doubles demand in seven years, quadruples it in 14 years, octuples it in 28 years, and you can see that they can't keep up 10%, but even if it dribbles down to 7%, 6%, and 5%, it's putting intolerable pressure on the world's resources.

We've had growth rates like China before. South Korea did it, but they did it with 20 million, and Japan did it with 60 million back in the '50s. They are doing it with 1.3 billion, and India trying to keep up with 1.2 billion--each of them have more people than were on the planet in 1800, and they're growing at 7% and 9% or 8%--inconceivable.

And it gives you three problems: Energy. We can handle energy if we're just sensible and start building solar power, wind power, and brilliant smart grids, all state-of-the-art by the way--grids that can reach in and turn your refrigerator off for half an hour and so on, and we’ll get by.

Metals, if we recycle like mad, we’ll have hundreds of years, but metals is a long topic. It is intractable, because in the end, you run out of metals, and the science fiction movies got that one right.

But the one that’s immediately pressing is food. We are losing the ability to distribute and feed poor countries as we sit. Food productivity has done very well, and the main reason it's done very well is this exhibit. We put on five times the fertilizer per acre that we used to as recently as 1960, just before I came to America. Five times is a lot. In China, they increased it 10 times by the crazy use of subsidies, so they over-fertilize.

At a certain point, fertilizer takes you backwards and ruins the environment and your waterways, as China is finding out. So there is diminishing returns. And the blue line--this is killer exhibit really for me. The blue line is the productivity of an acre of land. It comes in at 3.5% in the Green Revolution in the late '60s and early '70s. In the red line, the global population was peaking out at an astonishing 2.1% a year, and they have both declined steadily for population, erratically for productivity. Look where they are today: It is a dead heat at 1.2%. Explain to me, somebody, how are were going to feed the Chinese more beef and pork, which is what they want and not unreasonably. A pound of dressed beef displaces 30 pounds of grain, and pork displaces 12 pounds of grain, and we are in a dead heat--people alone are taking all our productivity gains. How are we going to feed them meat? And I’ll get to the answer.

This is China’s demand for animal feed, soy, soybeans; this is their import. China grows soybeans. They grew 14 million metric tons in '94. They grew 14 million metric tons last year. Every other ton was imported. It's going to be 60 million metric tons this year of soybeans will be imported. It has totally changed the agriculture of this hemisphere. North and South America have more acreage under soy today than they have under wheat, and all of this has occurred in 25 years to feed meat to China. These are stunning changes with great implications.

And we are hitting a glass ceiling, probably. The most productive wheat growers--U.K., Germany and France--have flattened off for 10 years. This is something the scientists have been fearing for a long time. The most productive rice grower is Japan, and they are flattening off for 15 years. And so, we have to look for the bad producers. But you can see these are all very finite. We live on a finite planet. We have finite resources, and we think we can grow exponentially. It does not compute; any mathematician knows that. And indeed there are several math professors who make very nice talks on this topic.

Agriculture has four important limiting factors to me. You got to have soil, water, phosphorous, and potassium, or potash and phosphate. You've got to have nitrogen. But nitrogen is in the air, you can fix it with crops, so I'm going to dismiss that. You've got these four.

We're running out of good arable land. We've lost at least a third since the beginning of agriculture. We've turned it into rock and stone. This last 100 years, we have been losing soil at 1% a year, which is 10 to 100 times faster than it's naturally replaced. Modern ag will just take us over the cliff unless we change it. That's just simple math. This is not a statement about the distant past. It's a statement about last year--1% a year erosion. No-till agriculture will do a pretty good job on that.

Water is a huge problem for a lot of countries, but not us. Most of the rich countries have decent access to water. Most of the trouble we suffer, and most of the trouble in the world, is incompetence. You've got to price water correctly, stop growing rice in deserts, obliterate Las Vegas, and stuff like this, and you can save tons of water, which brings us to these two.

Peak potash is a likely crisis. We have a lot of potash, but it's pretty unevenly distributed. So, you have to be nice to either the Canadians or the Russians. So, once again, we are very lucky. The U.S. and Canada, as a block, are going to sit back superficially fortress North America, while the world begins to run out of food. And unfortunately, the world will destabilize--is destabilizing already. This is not a distant future projection; this has been going on since 2002. The North African troubles, Arab Spring, was enormously affected by rising food and fuel prices, and will continue.

Egypt is a basket case. Egypt had 2 million people when Napoleon invaded. It has 82 million today, can you believe it? It's on its way to 120 million. It's baked in the population pie. They can feed about 55 million people. The rest of the food they import. They run a $5 billion trade deficit. They used to export oil, but last year and the year before, they imported it for the first time. The $5 billion [deficit] is going to $6, $7, $8, $10--who is going to provide that money or that food? My answer is nobody.

The solution to this problem is that we all behave sensibly in the developed world and the rest, and we will not. We will behave casually and in a spendthrift manner with lots of waste, and we will push the price up faster than it need rise, and we can afford it. Instead of paying 7% on resources, we'll pay 13%. Big deal. India, instead of paying 40% on resources, will pay 80%, and instantly starving--you get my point.

[There was] a lovely article in Bloomberg a week ago today, and it pointed out that the calorific intake of the average urban Indian in 1982 was 2,100 calories. That would make you lean and mean. It's 1,900 today. They pretend that they've doubled their GDP, but they have moved from the cheap countryside to the expensive urban world and they cannot afford to feed themselves. If they were to pull that stunt again, they won't be able to get a good days work out of anybody,

We're in, really, the beginning of a rolling crisis. What should you do? You should think favorably about resource funds. GMO is addressing this in every way that we can. We have a big timber capability of $4 billion, and we are moving to offer the same help in farm purchases for institutions. And we have a resource fund for stuff in the ground, including fertilizer critically. These are things that you can do. It's not how to get rich this year. The euro is going to be much more important. It's how to get rich for your sister's pension fund. What would you do with a 10-year horizon, 20-year horizon.

Phosphate, phosphorous, is the biggest problem of all. I spent two hours with the boss of the Moroccan phosphate company two weeks ago today, and you can see the problem. There is a mass of phosphate around in the world, and all of it, 85% of it, is in Morocco. And someone said, they are the Saudi Arabia of phosphorous, and I said, forget it, that's an insult. They're bigger than the OPEC of phosphorous. And so they are. These are the kind of problems we don't talk about, because they're inconvenient and because they threaten the long-term growth of the system, and that's just a plug for our tree operation.

I have a third part about the world gradually slowing down, and all the backup data, and the summary is, our productivity in the U.S. was 2.4% for 80 years until the last 30, where it dropped to 1.5%. Contrary to what Greenspan and a lot of people say and the tone of the press, our productivity has not been accelerating. This is unarguable data; it decelerated.

The equivalent number for the OECD, the rich countries club, which includes America, is 1.8%. How counterintuitive is that--that these clowns whose bottoms we've been kicking in productivity forever have had materially higher productivity than us for 30 years. But the point is, they weren't 1.8% either, they were 2.6%. So, ... everyone in the rich world has slowed down. Our population is slowing down. The hours worked per person is declining. The increase in women is finished in America 10 years ago. You can squeeze out a few more points in the rest of the world, the rich world.

But the rich world is going to have a negative increase in hours worked offered to the marketplace--forget the recession--offered to the marketplace a negative change, minus 30-40 basis points. And then everything will fall on productivity.

Productivity has a few things going against it. One of those is, of course, the very resources that I've been talking about, and I consider that a very important thing. The resources for the globe hit 4% of global GDP, and they are now back to 9%. 5% of global GDP has been sucked up. This is a short-term; you’ll see the great lump in '80, which was the twin oil crises. But 5 points of GDP, you can see how that might slow the growth down.

A rise of income inequality. The poor, they spend everything; the rich, we don’t. And that changes the game, I think, makes growth a little more difficult. Debt overhang--I’m not as impressed as everybody else--but I can agree that a world of increasing debt makes it a little easier to grow than a world where you are trying to pare it down, and we have a huge debt overhang.

The financial sector, basically, I’m afraid to say, guys, we are somewhat the blood sucker in this game. When I came to America, it was 3% of GDP; it is now 8%. What do we get for the extra 5%? We are reaching into the pockets of the rest of the world, the real world, and we are taking enough money out of that to leave them with less for investing in growth, and so on. And during this time period, the growth rate has indeed been slowing. So this has been a marginal effect also, and there are several others.

There's one positive for the U.S. only, really, and that’s natural gas fracking, and that, I think, will add 30 bps, 40 bps, maybe even 50 bps for 10 years, and then slow down pretty rapidly, and that will maybe offset for the U.S. all of those negatives that I mentioned, perhaps it won't quite. And for the rest of the world, they will simply decline in productivity.

So, this is the bottom line. The U.S. will be hard-pressed to grow at 2%, perhaps maybe 2.2% if natural gas really kicks in, and the rest of the rich world will be growing about 1.7%-1.8%. But we used to grow--America for 100 years, the battleship GDP was 3.4%. Now we're talking about 2%. And the same ratio, 40% drop, for the rest of the OECD. This is a huge decline. What effects will it have? And that's a question that we'll come back to.

So, questions? I don't know how we handle questions. I can't see anything from here.

Audience Member: This is a two-part question. In your 7-year forecast of real returns for both U.S. nominal bonds and index-linked bonds, they're both negative. How much lower would yields have to go before you would classify this as a bond bubble? And secondly would…

Grantham: No. No. I only do one at a time, otherwise I forget.

Audience Member: Okay.

Grantham: Bonds are horribly overpriced, but it's not a bubble. I like to think of a bubble as inflated by euphoria. Isn't that the case? I want to see wildness, and IPOs, and all those good things--the South Sea bubble, the Tulip bubble.

There are two reasons that bonds are hopelessly overpriced. One is, they're manipulated by the Greenspan-Bernanke logic, and ... the other is, of course, we are all nervous. So this is what I called the other day in this issue of Money magazine, this is an anti-bubble, isn’t it? Anti-bubble I can live with. It's caused by fear. The world is very jumpy. Institutional clients I was talking with yesterday--they are very jumpy, very, very jumpy--much worse than average. And that's why the other big reason. What was the second question?

Audience Member: Would it be fair to see that central banks and government fiscal policies are working to slow or stop regression to the mean? And if so, what does that imply for GMO's investment process?

Grantham: That is a very, very dirty question. Who asked that? You asked that. That's a splendidly dirty question.

The value managers, if you've noticed, have been having a tough time. Ken Heebner went from the best mutual fund to having bad 10 year numbers--bang! And the guy with the 14 years in a row--what's his face--he did the same. And a lot of people I won't mention to be polite have stumbled. Bright, bright people, hard-working people. It hasn’t been easy picking value stocks. Too many value traps, too many banks that go belly up, too many bookstores that get squeezed by the anaconda of the Internet that just won't let it go.

In the old days, everything was mean reverting. You had a bad CEO, you fired him, you got an average one, you went back up, or you got lucky. And you overbuild polyethylene, you stop building it, and it bounces back. The Internet is an interesting exception that might have changed the world for a bit. The Fed is an interesting idea. They allow, in general, changes to laws of nature and save people who should have gone, half the banks, etc., etc.

But something has changed, whether it's temporary or permanent I can't tell you, but that's a mean question.

Audience Member: When GMO thinks about normalizing U.S. profit margins, how do you think about and perhaps account for, adjust for, not adjust for, changes in the U.S. economy over the past 40, 50, 60 years--less commodity production and more software, and globalization, and so forth?

Grantham: I get the point completely. We believe that capital is capital, and capitalism has a certain return. The idea that one industry has a huge return, and one industry has a little return, and you say, tell me again why someone puts money into the little-return industry? After a bit, shouldn't they just get capital starved to such a degree that the return goes up? And if it's an obvious high-return industry, why doesn't everyone put their money in, and bid it down?

So, the theory, which is more right than wrong, is that there is a return to capital, and therefore, whether you're a service sector or a steelmaker, eventually everything tends toward to the same return, and that's, I believe, the case. So, we don't adjust for it, and we've tested it in history, and in history, you should not have adjusted for it. But every time, everyone wants you to adjust for it. In 2000, they said, aren't you going to adjust for the greater productivity of the Internet and the tech stocks?

It says "please wrap up." Okay. Thank you very much.

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