GMO

UARTERLY

ETTER

July 2010

Summer Essays

1 Portfolio Outlook and Recommendations

- Page 1

2 Finance Goes Rogue (But Volcker Wins a Round!)

- Page 3

3 The Fearful, Speculative Market

- Page 4

4 Everything You Need to Know About Global Warming in 5 Minutes

- Page 7

5 “Seven Lean Years” Revisited

- Page 9

6 Aging Populations, Pensions, and Health Costs

- Page 11

Portfolio Outlook and Recommendations

Well, I, for one, am more or less willing to throw in the towel on behalf of In

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ation. For the near future at least,his adversary in the blue trunks, De

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ation, has won on points. Even if we get intermittently rising commodityprices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to menow to be much the larger factor. Even three months ago, I was studiously trying to stay neutral on the “

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ation”issue, as my colleague Ben Inker calls it. I, like many, was mesmerized by the potential for money supply to increasedramatically, given the

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oods of government debt used in the bailout. But now, better late than never, I am willingto take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and in

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ationseems a distant prospect. Suddenly (for me), it is fairly clear that a weak economy and declining or

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at prices are theprospect for the immediate future.The worrying news is that most European countries, led by Germany (not surprisingly in this case), are coming onmore like Hoover than Keynes. More surprisingly, Britain and half of the U.S. Congress are acting sympatheticallyto that trend, which is to emphasize government debt reduction over economic stimulus. Yet, after a relatively stronginitial recovery, the growth rates of most developed economies are already slowing, despite the immense previousstimulus. You don’t have to be a passionate follower of Keynes to realize that to rapidly reduce de

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cits at this point isat least to

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irt with a severe economic decline. We can all agree that we had a

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nancial crisis, a drop in asset values,and an economic decline, all three of which were global (although centered in the developed countries), and all threeof which were the worst since the Great Depression. All three were destined to head a whole lot deeper into the pitwithout the greatest governmental help in history, also global. Yet despite this help, the economic recovery wasmerely adequate, unlike the stock market recovery, which was sensational and, as often happens, disproportionate tothe fundamental recovery. But in the last three months, more or less universally in the developed world, there hasbeen a disturbing slackening in the rate of economic recovery. (Perhaps Canada and Australia on their own look okay,propped up by raw materials and, so far, un-popped housing bubbles.)I am still committed to my idea of April 2009 that there would be a “last hurrah” of the market, supported psychologicallyby a substantial economic recovery but then, after a year or so, that this would be followed by a transition into a long,dif

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cult period that I called the “seven lean years.” I had, though, supposed that the economic re

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ex recovery – howcould it not bounce with that

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ood of governmental help to everyone’s top line? – would last longer or at least not slowdown as fast as we have seen in the last few weeks. And with unexpectedly strong

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scal conservatism from Europeand perhaps from us, this slowdown looks downright frightening. I recognize that in this I agree with Krugman, but Ican live with that once in a while. However, where I am merely fearful, he is talking about another “Depression.”

Jeremy Grantham

GMO

Summer Essays – July 2010

At GMO, our asset allocation portfolios, however, are merely informed on the margin by these non-quantitativeconsiderations. They draw their strength from our regular seven-year forecast. Today this forecast (see Exhibit 1)suggests that it is possible to build a global equity portfolio with just over the normal imputed return of around 6%plus in

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ation. With our forecast, this can be done by overweighting U.S. high quality stocks and staying very lighton other U.S. stocks. At a time when

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xed income is desperately unappealing, this, not surprisingly, results in ouraccounts being just a few points underweight in their global equity position, which is suddenly a little nerve-wrackingas the growth of developed countries slows down. A little more dry powder suddenly seems better than it did a fewweeks ago, but then again, prices are 13% cheaper. I regret not having seen the light a few weeks earlier. Runningat the same rate of change in attitude as both the market and general opinion is both frustrating and unpro

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table. Buteven as global equities approach reasonable prices, I would err on the side of caution on the margin.Let me give a few more details: just behind U.S. high quality stocks, at 7.3% real on a seven-year horizon, is mylong-time favorite, emerging market equities at 6.6%. This is now above our assumed 6.2% long-term equilibriumreturn. Additionally, my faith in an eventual decent P/E premium over developed equities exceeding 15%, perhapsby a lot, is intact. Emerging equities’ fundamentals also continue to run circles around ours. EAFE equities at 4.9%are a little expensive (6% or 7%) but make a respectable

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ller for a global equity portfolio. Forestry remains, in myopinion, a good diversi

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er if times turn out well, a brilliant store of value should in

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ation unexpectedly run away, anda historically excellent defensive investment should the economy unravel. Otherwise, I hate it.

6.5% Long-term Historical U.S. Equity Return

Estimated Range of7-Year Annualized Returns

*The chart represents real return forecasts

for several asset classes. These forecasts are forward-looking statements based upon the reasonable beliefs of GMO andare not a guarantee of future performance. Actual results may differ materially from the forecasts above.

StocksBondsOther

Long-term inflation assumption: 2.5% per year.

±6.5±7.0±6.0±7.0±10.5±4.0±4.0±8.5±1.5±1.5±5.5±6.5

2.9%1.1%7.3%4.9%2.9%6.6%0.1%-0.8%2.2%0.5%-0.4%6.0%

-2%0%2%4%6%8%

U.S.equities(large cap)U.S.equities(small cap)U.S. HighQualityInt'l.equities(large cap)Int'l.equities(small cap)Equities(emerging)U.S. Bonds(gov't.)Int'l. Bonds(gov't.)Bonds(emerging)Bonds(inflationindexed)U.S.treasury(30 days to2 yrs.)ManagedTimber

A n n u a l R e a l R e t u r n O v e r 7 Y e a r s

Source: GMO

Exhibit 1GMO 7-Year Asset Class Return Forecasts*

As of June 30, 2010

GMO

Summer Essays – July 2010

Other Advice

Don’t walk in the woods any more than you have to these days. Don’t get sick until September, when medicalpractitioners’ vacations end.

The Girl with the Dragon Tattoo

really is as readable as they say, and the movie is evenbetter. The Sharpe series by Cornwell is the easiest read ever and a painless way to pick up some Napoleonic history.

War and Peace

is the most self-indulgent, overwritten work ever. There is, though, a great 600-page novel lurkinginside it. 4,300 clicks on my Kindle! Have a good summer!

Correction

I mentioned in last quarter’s

Letter

that UBS had

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red the inestimable Gary Brinson at the peak of the 2000 bullmarket. This turned out to be incorrect, as Gary was not

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red. He and UBS had agreed to his withdrawal for a varietyof personal and other reasons some considerable time earlier. No negatives were meant to be applied to Gary. Quitethe reverse. Being

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red for standing one’s ground for a good cause is always an honorable activity in my opinion.My apologies.

Finance Goes Rogue (But Volcker Wins a Round!)

My previous argument in the

Economist

debate*was that the 3% of GDP that was made up of

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nancial servicesin 1965 was clearly suf

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cient to the task, the proof being that the decade was a strong candidate for the greatesteconomic decade of the 20

century. We should be suspicious, therefore, of the bene

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ts derived from the extra4.5% of the pie that went to pay for

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nancial services by 2007, as the

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nancial services share of GDP expanded to aremarkable 7.5%. This extra 4.5% would seem to be without material value except to the recipients. Yet it is a formof tax on the remaining real economy and should reduce by 4.5% a year its ability to save and invest, both of whichdid slow down. This, in turn, should eventually reduce the growth rate of the non-

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nancial sector, which it indeed did:from 3.5% a year before 1965, this growth rate slowed to 2.4% between 1980 and 2007, even before the crisis.This bloated

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nancial system was also increasingly deregulated and run with increasing regard for pro

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t and bonuspayments at all cost. Thirty years ago, Hyman Minsky could have told you that this would guarantee a major

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nancialbubble sooner or later and at periodic intervals into the inde

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nite future. This unnecessary explosion in the sizeof the

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nancial world has been a clear example of the potential for dysfunctionality in the capitalist free marketsystem. I have not been a great fan of the theory of rational expectations – the belief in cold, rational, calculatinghomo sapiens; indeed, I believe it to be the greatest-ever failure of economic theory, which goes a long way towardexplaining how completely useless economists were at warning us of the approaching crisis (with a half handful of honorable exceptions). But it would be a better world if their false assumptions were actually accurate ones: if onlyinformation

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owed freely, were processed ef

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ciently, and were available equally on both sides of every transaction,we would indeed live in a more ef

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cient and probably better world. The problem that information is asymmetricalin the

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nancial business is a serious one. One side of the transaction, say an institutional pension fund, is often at themercy of the other, say the prop desk of a talented and mercilessly pro

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t-oriented investment bank.The problem of asymmetrical information is compounded by the confusion between the roles of agent and counterparty.I grew up in a world where stocks and other

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nancial instruments were traded by the client with a high degree of trustin the agent. Millions of dollars traded on a word, without a tape recording. Somewhere along the way, without anyformal announcement of the change, the “client” in a trade mutated into a “counterparty” who could be exploited.Steadily along the way, the agents’ behavior became more concerned with the return on their own trading capital thanwith the well-being of their clients. One of my nastiest shocks in 45 years was the realization one day in 1985 that wehad been ripped off by our then favorite broker on one of the early program trades we were doing. We had supposedwe had developed a trusting relationship. We had certainly done many incentive trades that were successful from ourpoint of view. Perhaps, with hindsight, our strong incentives might have merely motivated them to rip off some otherclient.

* http://economistevents.pb.feedroom.com/economist/economistevents/oneclipgreen/player.html?fr_story=2f1833380e67f2003162128192dedd493ec291d0