GMO letter for the second quarter ended June 30, 2016; titled, “The Duration Connection.”
GMO – The Duration Connection
Over the last six or seven years, most financial assets have done very well. The performance divide has not been between low-risk assets and high-risk assets or between liquid assets and illiquid assets, but between long-duration assets and short-duration assets. Long-duration assets such as stocks, bonds, real estate, and private equity have benefitted from a large fall in the discount rate associated with their cash flows, while short-duration assets have been hurt by the same fall. Investors tend to tilt their portfolios in favor of those assets that have done well, and today that pushes them to be increasing effective duration in their portfolios, just when the potential returns to those assets have dropped. What we believe would be most helpful to investors are short-duration risk assets, as they offer the potential of decent returns over time with less vulnerability to rising discount rates. These assets, generally lumped together under the “alternatives” title, are generally out of favor today given their disappointing performance since the financial crisis, but the characteristics that made them disappoint may well prove a blessing if discount rates start to rise.
In most of the economic ways that count, the years following the financial crisis have been somewhere between disappointing and unspeakably bad. Economic growth in the developed world has been slower than at any comparable period barring the Great Depression. Productivity growth has been the worst since the invention of GDP,1 and corporate investment has remained stubbornly low. According to a McKinsey Global Institute report, two-thirds of households in the developed world had incomes as of 2014 that were flat or fell relative to 2005 (81% of households for the US in particular).2 After a burst of growth in the emerging world associated with China’s enormous stimulus policy of 2008-10, growth has also come to a crawl in the emerging economies, laying bare corruption and structural problems that appeared to be minor when times were better. But in one way, the last seven years have been a glorious success. Performance of most financial assets has been very strong, with assets from US equities to global real estate and infrastructure to credit and government bonds all giving strong returns. Even the laggards – non-US developed and emerging equities – have been disappointing on a relative, though not really an absolute basis. It isn’t all that often that everything does well at the same time. We have been conditioned to think of stocks and bonds as complements to each other, with one doing well when the other does poorly. In this cycle, we’ve gotten an almost magical benefit, where on a daily basis the correlations have been negative, but over the full seven years both assets have gone up strongly, along with most other assets. Apart from emerging equities, the only assets that have really disappointed seem to be commodities, cash, hedge funds, and other hedge-fund-like alternative assets and strategies. We believe there is a common factor that explains much of this. We believe further that it is important to realize that the strong returns to the assets that have done well over the last seven years are at best a one-off benefit and, more plausibly, will have to be given back over time. To us, this suggests that while alternatives have been a drag on institutional portfolios over the last six or seven years and privates (real estate, private equity, venture capital) have been a boost, in coming years the reverse may well be true.
The duration effect
The common factor that explains much of the return pattern we have seen in recent years is duration. The assets that have done well do not necessarily share that much in common, but they do all share a structure that they embody at least somewhat predictable cash flows that will occur over an extended period of time. The value of those cash flows changes materially if the discount rate applied to those cash flows changes. We are used to talking about the duration of fixed income instruments, but not necessarily for assets like equities, real estate, LBOs, etc. But all of these assets can readily be valued through a discounted cash flow process, and the sensitivity of the present value to a change in the discount rate is precisely analogous to the duration of a fixed income security.
And what has happened to those discount rates is pretty uniform across asset classes.4 Table 1 shows an estimate of the change in the discount rate from a 2009-10 average to year end 20155 along with an estimate of the effective duration of the asset class with regard to that change.
Emerging equities is the only asset class for which the discount rate seems to have risen over the period, and that move certainly does feel idiosyncratic to emerging. Otherwise, discount rates have fallen somewhere between 1% and 3%, with a median of 1.5% and an average of 1.7%. But while the discount rates have all done similar things, the impact on asset classes has varied because of differing durations of the assets. I apologize for the overly precise effective durations for the asset classes in Table 1. They range from mathematically true for the government bonds, to true for a given split between growth and income for equities, to educated guesswork in the case of private equity and venture capital. But, to me, the striking discrepancy is between the first 11 asset classes and the last 3. For any asset with a long duration, the discount rate fall has been a decided positive for returns for the asset class. But for short duration assets, it has actually been a negative. This occurs because there are two sides to the fall in discount rates. It increases the present value of distant cash flows, but it also decreases the current income available on the asset. The negative side of this is simplest to think about in the case of cash. Cash is the purest short duration asset. If cash rates fall, there is no capital gain to enjoy, but the income earned in subsequent periods will be reduced. The 3% fall in the discount rate for cash in this case means that relative to the 2009-10 market expectation of where cash rates would be at the end of 2015, we actually wound up 3% lower. As a result, the impact of the fall in the discount rate was approximately -1.5%.7 That is to say, relative to market expectations from 2009-10, cash investors achieved about 1.5% less than they originally bargained for through 2015. The impact for a holder of a constant maturity 30-year Treasury bond portfolio, on the other hand, was a windfall of 3.8%. Yes, the investor did receive less income over the period because the yield on the bonds fell, but that impact was swamped by the gain from the higher present value of the future cash flows. We can see this for all of the assets in Table 2.