That question should be easy to answer. The Fed will do what it has always done: cut interest rates to stimulate economic activity. Except that this time, the Fed has little room to cut. Past recessions saw the Fed reduce the benchmark rate an average of 4–5 percentage points. Doing the same this time would put the federal funds rate well below zero.
That’s right – NIRP in America. It can happen here. Worse, some people want it to happen here, among them Harvard economist Kenneth Rogoff. In a recent paper reported by Bloomberg, Rogoff wrote: “The growth of electronic payment systems and the increasing marginalization of cash in legal transactions creates a much smoother path to negative-rate policy today than even two decades ago.”
I am on record as saying NIRP will be a disaster if imposed in the US. I still believe it. I would like to be able to assure you that whoever takes the reins at the Federal Reserve next year will agree with me that NIRP is dangerous, but we don’t know who that will be. President Trump is in no hurry to remove that uncertainty, either. It is entirely possible that the Fed’s Board of Governors will have an entirely new ruling coalition this time next year, and it might well include NIRP advocates like Marvin Goodfriend.
Where that outcome would lead us is anyone’s guess, but I’m confident it would not be bullish for US stocks.
The S&P 500: Just Say No!
My friend James Montier, now at GMO, and his associate Matt Kadnar have written a compelling piece on why passive investors should avoid the S&P 500. Their essay, entitled “The S&P: Just Say No,” argues that the forward growth potential of the S&P 500 is significantly lower than that of other opportunities, especially emerging markets. Let’s look at a few of their charts.
The chart above breaks the total return from the beginning of the current bull market in the S&P 500 into its four main components: increasing multiples, margin expansion, growth, and dividends. He notes that this total return is more than double the level of long-term real return growth since 1970.
If earnings and dividends are remarkably stable (and they are), to believe that the S&P will continue delivering the wonderful returns we have experienced over the last seven years is to believe that P/Es and margins will continue to expand just as they have over the last seven years. The historical record for this assumption is quite thin, to put it kindly. It is remarkably easy to assume that the recent past should continue indefinitely, but it is an extremely dangerous assumption when it comes to asset markets. Particularly expensive ones, as the S&P 500 appears to be.
More bluntly put, the historical record supporting this assumption is nonexistent. It never happened. Just saying…
The authors then describe how they build their seven-year forecasts of S&P 500 returns. They argue that for the next seven years returns will be a negative 3.9%. Note that GMO is not a perma-bear money-management business. Their forecasts were extremely bullish in February 2009. They are a valuation shop, pure and simple. Investors – typically large institutions and pension funds – that are leaving Grantham’s management firm now are going to regret it. The consultants or managers who suggested that move are going to need to polish their résumés.
The bottom line? “The cruel reality of today’s investment opportunity set is that we believe there are no good choices from an absolute viewpoint – that is, everything is expensive (see Exhibit 10). You are reduced to trying to pick the least potent poison,” the duo says. Their Exhibit 10 is shown below.