Ben Inker Transcript 4/19/2013 #943

April 19, 2013

CONSUELO MACK: This week on WEALTHTRACK, investment strategies for dangerous markets. GMO’s next generation Financial Thought Leader, Ben Inker discusses the unprecedented challenges of a hyperactive Federal Reserve and historically low interest rates. Asset allocation for unusual times is next on Consuelo Mack WEALTHTRACK.


Hello and welcome to this edition of WEALTHTRACK. I’m Consuelo Mack. We live in unusual times. Central banks around the world, led by the Federal Reserve, have taken unprecedented actions to stimulate economic growth, prop up indebted governments, and bail out troubled banks. And because it is an experiment, no one quite knows how it is all going to turn out. One thing we do know for sure is the series of ground breaking actions by the Federal Reserve – keeping short term interest rates near zero for years and more recently buying $85 billion worth of treasury bonds and mortgage backed securities every month- have kept interest rates artificially low. The Fed’s policies are being called “financial repression” by some on Wall Street. What we don’t know is how it’s all going to turn out.

What happens when the Fed and other central banks decide being this involved in financing governments, banks, and credit markets is either no longer necessary or counterproductive? That is a question many of our WEALTHTRACK guests are extremely concerned about. Several recently called the bond market downright dangerous. But most investors seem far less concerned. According to TrimTabs Investment Research, bond funds are booming. They had sizable inflows in the first three months of the year for the 17th quarter in a row- $72.3 billion worth. And unlike stocks, investors still favor actively managed funds by a huge margin. Over the last 12 months, bond mutual funds have seen inflows of nearly $280 billion versus $44 billion into fixed income ETFs. As TrimTabs points out, so much for the “great rotation out of bonds and into stocks. No such rotation has materialized.”


This week’s guest is strongly in the “bonds are dangerous” camp. He is Ben Inker, co-head of Asset Allocation at GMO, which stands for Grantham, Mayo, Van Otterloo, the last names of the three investment professionals who founded the global investment management firm in 1977. By far the most famous of the three is Jeremy Grantham, its chief investment strategist. GMO and Grantham are known for bold market calls and spotting market bubbles: Japan in the mid-eighties; the tech bubble, several years early in the nineties; the housing bubble in the 2000’s; the market low exactly in March of 2009. In recent years, including now, they have been warning of perils in the bond market. Ben Inker has worked at GMO his entire career since graduating with a BA in Economics from Yale in 1992. He is co-head of GMO’S Asset Allocation team, a member of the firm’s board of directors, portfolio manager of several of GMO’s asset allocation portfolios for institutional and high net worth individuals, which have mutual fund equivalents for the rest of us under the Wells Fargo name: Wells Fargo Advantage Asset Allocation and Wells Fargo Advantage Absolute Return. I began the interview by asking Inker to give us the world as GMO sees it.


BEN INKER: Well, the world, as GMO sees it, is a place with not that many cheap assets, but where you’ve got to work pretty hard to find some assets worth buying. Central banks around the world have engineered a situation where you can’t afford to keep your money sitting in the bank, because it will earn nothing.




BEN INKER: But that’s driven up the prices of assets all over the world, even in places like Europe, where things are not going very well. The prices have still been levitating. So what we think you have to do is figure out how much risk you’re willing to take, given that there aren’t a lot of really cheap assets, and where can you find some assets that are worth the risks that you’ve got to take right now.


CONSUELO MACK: So is this a very unusual time because of what people describe as financial repression? The fact that the central banks around the world have been so active in the markets in keeping interest rates low, and many people say artificially low. So is this really an extremely unusual time?


BEN INKER: Yeah. I don’t think we’ve ever seen anything like it. If you look back through history, there just haven’t been any times where interest rates so many places around the world have been so low, and clearly are being pushed there. This is not the market pushing it there. It is central bank action pushing it there. And they’re doing it for a specific reason. If you listen to what Ben Bernanke and the Federal Reserve are saying, they’re saying one big reason why they’re doing quantitative easing is to push up the prices of risky assets.




BEN INKER: So we’ve got a specific policy by central banks to try to make risky assets more expensive. To some degree they have succeeded, but that is a dangerous game to play, right? They’re pushing up the prices of stocks, but not particularly because they really care about the owners of stocks. They’re pushing up the prices of stocks because they’re hoping it will help the economy. But what they really care about is the economy. So if the economy ever really gets going, you’ve got to be pretty careful about decisions you made based on decisions they made when the economy wasn’t going very well. So we think it’s a tricky time. It is hard, because we’d love to be able to invest without worrying about what the Federal Reserve was doing. You can’t do that now, given how incredibly active they are in the markets. But it creates a situation where there is significant risk, and one of the risks that you have to face right now, which is not normal for investors, is the risk of the economy actually getting back on its feet.


CONSUELO MACK: Oh, how interesting. That’s a problem?


BEN INKER: Yes. That could wind up being a problem, because if you think about it, we’ve got extraordinarily easy monetary policy, so interest rates right now are two percent less than inflation. Extraordinarily low. Really just about the lowest we’ve ever seen in history.


CONSUELO MACK: And you’re talking about short-term interest rates, and inflation is running about two percent, and we’re at zero percent, as far as short-term interest rates are concerned.


BEN INKER: Exactly. And that works right now, because there is a lot of slack in the economy. We’ve got unemployment of 7.6%, and so price pressures aren’t really there in the real economy. But if the economy does get traction, and we get back to a more normal situation, capacity utilization starts rising, unemployment starts falling, and there’s less spare capacity, well, all of that money might lead to inflation, and if it did, interest rates would have to rise in a really sharp fashion. Right now, they can afford to have interest rates significantly below the rate of inflation, but let’s imagine inflationary expectations started to rise. So they’re at two percent now, they get to be four percent, and suddenly the Federal Reserve says, “Well, wait a minute. We don’t want four percent. We like two.” Well, the problem is the way to get those inflationary expectations down from four to two is you’ve got to raise real interest rates.


So you’ve got to raise interest rates not just the two points that are the amount by which inflation went up, but then you’ve got to raise them by more, and you really have to get interest rates above the rate of inflation. So if we’re zero now, which is two points less than inflation, we might have to get up to five or even six then to be greater than inflation. And so that would be a disaster, certainly for bond investors. It probably wouldn’t be very good for stock market investors, or real estate. So it’s one of those things that’s a risk you’ve got to be … you’ve got to have in the back of your mind. It’s not happening now, but if it did happen, it could really blow a hole through your portfolio.


CONSUELO MACK: And what’s interesting is that it’s inflation expectations that you’re talking about, and inflation expectations as measured by the things that the Fed looks at, that measures inflation what, two or four years down the road. So it’s not even as if you’re seeing inflation go up, but it’s the expectation of. So it’s all of these nebulous things that could have a huge impact on the markets.


BEN INKER: Exactly. And we’re seeing that absolutely going on right now in Japan, where the Bank of Japan has done absolutely extraordinary statement of how much they want to expand their balance sheet.


CONSUELO MACK: There’s no limit, right, essentially?


BEN INKER: No limit. And they’re doing it until inflationary expectations get up to two percent. So what they’re interested in is not directly what is inflation in Japan, but what do people think inflation will be going forward, because they want people making decisions based on the idea that there will be inflation. And it’s a tricky game to play, and we’ll see how it turns out either in Japan or the U.S., but it’s a situation that we haven’t seen in the past, and so understanding the implications for asset prices is… it is harder than usual.


CONSUELO MACK: So there you are. You’re co-head of asset allocation at GMO, and you are running portfolios. You have to make these decisions. So where have you come out? What’s your asset allocation strategy right now?


BEN INKER: So in portfolios where… what we’re really trying to do is to beat inflation. So we want to get just absolute returns for clients. And what we’re concerned about is a loss of purchasing power parity for them. So if we’re looking at a portfolio like that, if we really loved equities, if they were really cheap, maybe we would have 75 or 80% of our money in equities. If equities were really horrific, we’d be at zero. Right now we’re kind of 53%.




BEN INKER: Equities. Down a couple of points from earlier in the year, because equities have had a strong rally. But in some ways it would be lovely to take more money off the table in equities, because we’ve just seen a pretty strong rally on the back of not immensely good profits, or at least profit growth, or economic information. It would be great to take more money off the table. The problem is if you think about where you’d put it, well, you can put it in cash and earn nothing. You can put it in bonds and earn next to nothing, and have significant risks, if inflation came back. You know, you could put it in high-yield bonds, but that market has gotten pretty frothy. So it’s really a bit of a tricky balancing act. We want to make sure we don’t put the clients at too much risk of losing a significant amount of money. First and foremost, we think the way to make money in the long run is to make sure you never lose too much money.


CONSUELO MACK: Right. Oh, absolutely.


BEN INKER: So we’re taking a little bit of risk off the table, running…


CONSUELO MACK: And so that means raising cash or…


BEN INKER: Raising cash-like stuff.


CONSUELO MACK: Like what kinds of vehicles represent cash-like stuff?


BEN INKER: You know, it gets a little bit complicated. What we’re looking for is techniques to try to add a point or two, a percentage point or two on top of cash without taking credit risk, or stock market risk, or duration risk associated with being in bonds.


CONSUELO MACK: So are there vehicles out there that allow you to do that?


BEN INKER: We’ve got a couple. And what they’re effectively doing is going long and selling short different assets around the world…




BEN INKER: …to try to generate uncorrelated returns- a little like what hedge funds do, but without the leverage. And so we’ve been putting more money into strategies like that. One of the things we really like about them is we think it’s effective dry powder. What we really would love is for some asset somewhere around the world to actually go down in price, get really cheap. If that happens, we want to be in a position to put that money to work quite quickly. And so these assets, which remain very liquid, and shouldn’t go down, even if the world has a tough time, are really good places to raid, to put money back to work in risky assets quickly.


CONSUELO MACK: So that’s in the absolute return, again, preserving your purchasing power. I mean talking about cheap assets, so where in the world are equities? Cheap, or at least fairly valued? Or not overvalued?


BEN INKER: There’s a few places where they’re not bad. I wouldn’t say there’s any place where they’re cheap. And it’s interesting, despite the fact that there’s a lot of expensive stock out there, there are some cheap pockets in various places around the world. So in the U.S. we do find attractively priced stocks in the high-quality sector. So big, stable blue chip companies, without much debt. They’re priced at a discount to the market, and they’re normally priced at a premium. So we think they have a better expect to return than the rest of the market, and one nice thing is, we think they’re less fundamentally risky if something bad should happen.


CONSUELO MACK: So these are like the, I don’t know, Johnson and Johnson, the Coca-Colas, I mean the household names that we would all know. Now, I thought that those were attracting a lot of money at one point, because people were looking for dividends, for instance, and dividend growth, but they’re as a group, or relative to other stocks…


BEN INKER: Yes. As a group we think that they are actually pretty cheap. And that is actually quite different from a high dividend yield portfolio. High dividend yield has gained a lot of assets. And if you look at the valuations of high dividend yielding stocks, they’re actually trading at a higher valuation relative to the market than we have seen kind of 95% of the time. So they’ve been pushed up to high levels relative to their history. The Johnson and Johnsons, the Coca-Colas, the Microsofts are actually trading at a significant discount to their history. So while they’re not unrelated, the pressures seem to have gone in different directions. And so we do think that there’s a significant opportunity there- not to get you rich, but at least to keep you rich if you’re started out rich, which is, at this point, not a horrible thing.


And the other places that we do see some value are riskier. So within continental Europe we see some cheap stocks. They tend to be the slightly junkier end of things. They tend to be the European stocks that are more European.


CONSUELO MACK: In other words, their business is in Europe, right, and that’s what people are just saying, I want to avoid that, but…


BEN INKER: Exactly.


CONSUELO MACK: So that’s where opportunities…


BEN INKER: Yes. So people are saying if I’ve got to buy a European stock, I want to buy Nestle, because they don’t do that much of that business in Europe. What you find are cheap or they’re companies that actually have all their business in Europe, and they have gotten hit pretty hard. Their earnings are down. Their sales are down. But they’re trading pretty cheap. If you didn’t have to be worried about the prospect of a really bad economic outcome in Europe, I think we could say, “Hey, these stocks are cheap in absolute terms.”


CONSUELO MACK: So are these like telephone companies, or…


BEN INKER: Some of the telecoms and utilities. Some of the kind of more cyclical companies or media companies that are really European are trading at attractive valuations. The trouble is if you start thinking through the various scenarios in Europe, there are some scenarios where these companies don’t just do badly for a while, but they kind of go down and those losses are permanent. So there are plenty of companies that will make you a lot of money if Europe recovers nicely from here, but you have to run the risk if Europe doesn’t that you will take some losses.


The other place where we see some opportunities is in the emerging world, which… it’s funny, a few years ago everyone talked about how emerging is where the growth is, and, of course, these guys should trade at big premiums to the developed countries, and now suddenly, you know, these companies are trading at ten, eleven times earnings, and everybody is saying, “Oh, I don’t want to touch them. These are too risky.” They are risky. And we can definitely see situations where they will go down further, but in terms of places where you’re getting paid for taking risk, European value and emerging markets are two of the better ones.


CONSUELO MACK: You’ve got a tough job, I just realized, in trying to, you know, finesse these very tricky waters here. So one of the questions that you’ve raised in the past, given what’s happening with, again, this financial repression of artificially low interest rates, is what role do bonds have in your portfolio. So what role should bonds have in our portfolio in this day and age?


BEN INKER: Well, the way we think about it, if what you are attempting to do is get returns above inflation, so you’re trying to fund your retirement, you’re trying to fund spending, it’s not clear what role bonds play right now. Certainly, U.S. Government bonds, out to ten years and beyond, have yields that are lower than expected inflation. So you are signing up to lose money after inflation. And in the scenario I talked about before, where the economy actually gets back on its feet, they could do disastrously badly. So the likely outcome is you lose a little bit of money, but there’s the potential to lose a lot of money.


What we’d rather do right now is have money in cash-like assets or cash, and be bleeding a little bit more now, relative to inflation, because we’re making ten basis points, and inflation is two percent, but at least be in a position where if things improve, we won’t take a loss. And if things get worse, the nice thing is, well, that should really cause some risky assets somewhere to get cheap, and then we can take that cash and put it to work in places where we’re getting paid a lot to take risk.


CONSUELO MACK: So another issue that you brought up is corporate profits, and the fact is, I think that you’re predicting that corporate profits are actually going to fall.


BEN INKER: Yes. So it’s one of the things that we’re having a little bit of a hard time getting our clients to understand. We think that the economy will improve. I don’t know exactly when, but it should gradually improve over the coming years, and yet, we expect that that will be accompanied by falling corporate profits rather than rising corporate profits.


CONSUELO MACK: And not actually actual declines, but just a deceleration, right, or actually falling?


BEN INKER: It could be an actual falling.




BEN INKER: Not sure. It’s going to be hard for profits to grow by much, and they might actually shrink, even in a decent economy.


CONSUELO MACK: So how’s that going to happen?


BEN INKER: The costs that you can cut are labor, and if you cut people’s incomes, they’re going to spend less. And we’ve got an economy which is 70% household consumption, so you cut incomes, you cut consumption, you cut the economy. Well, this time, the government stepped in, and what they did was they replaced all of that labor income. So we went from a situation where the government ran deficits of two or three percent of GDP, and we had decent labor incomes, to a situation where labor incomes fell significantly as a percent of GDP. But the government stepped in with tax cuts and transfer payments to make up that lost income. Well, now the government is pulling back.


CONSUELO MACK: Pulling back, right. So is this going to be kind of a, you know… GMO is famous for its seven-year forecast. Is this going to be kind of a muddle through type of scenario with, you know, subpar growth in lots of different parts of the world, and subpar investment returns? Or what?


BEN INKER: The inflation-protected bonds are guaranteeing that you’ll lose money after inflation. The standard bonds, the same thing. Cash, the same thing. Equities are priced to do better. The stock market is not wonderful, but it’s better than bonds or cash. The difficulty is we’re playing this weird game, you know. There are bad things on either side. If the economy gets much worse, we have real problems. If the economy gets much better, we may have real problems. If the Federal Reserve and the government can get us on this narrow path, we’ll be okay, economically we’ll be okay, and we won’t take big losses in the stocks or the bonds, but it’s hard to see how you can ride anything to glory right now.


CONSUELO MACK: One investment for long-term diversified portfolio… we always ask each of our guests, is there one investment that we should all own some of?


BEN INKER: Well, we do like the high-quality stocks in the U.S. It’s one group that you can buy and not have to worry too much about what happens to the global economy. I think the expected return through European value stocks are better, or emerging market stocks are better, but there are scenarios where those turn ugly. And the nice thing about the high-quality stocks is that they’re priced to do okay, and they should do okay even if we go down one or the other of the difficult paths.


CONSUELO MACK: We will leave it at that, Ben Inker. And, again, I do not envy you your job, whatsoever. This is a tough time to be an asset allocator. Thank you very much for joining us on WEALTHTRACK.


BEN INKER: Thank you.


CONSUELO MACK: GMO is famous for its 7 year forecasts for various asset classes. They are done in real terms, meaning without the effects of inflation. It is expecting annualized real returns of 4% for high quality U.S. stocks, but it’s highest stock expectations are nearly 6% returns for emerging market equities. It expects negative returns for bonds, except emerging market debt where it estimates around 2% average annualized returns. Today’s Action Point focuses on a much maligned asset class that GMO and Inker value highly. It is cash. So our Action Point is: recognize the value of cash in your portfolio. And life for that matter!


Inker and his asset allocation team are holding substantial amounts of cash and cash equivalents to protect their clients’ portfolios from losses in the other assets which they consider expensive and high risk. As Inker said, having cash will enable them to buy risky assets when they get cheap again. Cash is conservative, contrarian, and protective in unusual times like this.


Next week, we will have an exclusive interview with legendary small cap fund manager Chuck Royce, who will share valuable lessons learned from 40 years at the helm of the Royce Pennsylvania mutual fund, which has beaten the market by a wide margin with less volatility than the markets over the decades. If you have missed any of our past Great Investor or Financial Thought Leader guests, you can find them on our website, You can also see additional and extended interviews in our WEALTHTRACK Extra feature, including a fascinating story by Ben Inker of how he was hired by GMO as an undergraduate right out of Yale. It wasn’t as seamless as it sounds.


And we are marking a milestone on WEALTHTRACK. Our wonderful longtime editor, Kerry Soloway, who has been with us since the beginning, is taking a full time job at public television, which means their huge gain and our loss. He has been much more than an editor for us. He is a true professional, friend and inspiration. Thank you all so much for taking the time to visit with us. Have a great week and make it a profitable and a productive one.




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