September 5, 2012

PIMCO’s Bill Gross: ‘The Age of Inflation Is Upon Us’

Credit lenders are frugal, will not indulge ‘obese’ borrowers

Bill Gross (left), Liz Ann Sonders and Tyler Mathisen at Schwab Impact in 2011. Bill Gross (left), Liz Ann Sonders and Tyler Mathisen at Schwab Impact in 2011.

In typical Bill Gross style, the head of the world’s largest bond shop employs the Lindy dance craze, former Citigroup CEO Chuck Prince, the Wimpy cartoon character and his dying cult of equity argument in a mash-up of prose to describe the “age of inflation that is upon us,” which he claims typically “provides a headwind, not a tailwind, to securities prices in both stocks and bonds.”

In his monthly outlook for September he begins, as usual, with a bit of history.

“Credit, of course, is what makes the global economy go …Wimpy said it best, ‘I’ll gladly pay you Tuesday for a hamburger today,’” Gross writes. “So McDonald’s grew from a million to 500 billion served and Wimpy and his wimpalikes were delighted in the exchange, although their arteries and midsections inevitably came out a loser … But in order to promote and indeed foster continuing symbiosis, both borrower and lender need to operate in a nutrient-rich environment, a “credit” petri dish of sorts which fosters strong bones and healthy lenders and borrowers in their adult years. That unfortunately does not seem to be the case.

Wimpy’s weight-challenged midsection, he continues, is an “obvious testament to the overleveraged condition of today’s global borrowers. Too much debt leads to forced diets and de-levering, a process which has been ongoing since Lehman 2008. Borrowers are just not in a healthy place and if history is our guide, their restoration may be almost biblical in terms of timing: seven years of fat followed by seven years of lean—perhaps even longer.”

Gross adds lenders will not easily lend money to an obese over-indebted borrower, but will also not extend a check when the yield, carry and return on investment is so low that it cannot compensate for historic business model overheads. When yields are too low, and acceptable risk spreads so narrow that top-line interest revenue is increasingly marginalized, then lending is at risk.

What then is an investor to do? Gross cites his widely read and controversial post from August.

“Last month’s ‘dying cult of equity’ Investment Outlook elicited a lot of excitement, but somehow failed to impress readers with its main point: Returns from both stocks and bonds will be stunted. How could one argue otherwise on the bond side with investment grade bonds yielding only 1.75%? How could one argue otherwise for stocks under the assumption that bond and stock returns were at least in part mathematically conjoined at the hip? How could one argue otherwise when it is obvious that boomers and Xers, Ys and Zers are likely to be disenchanted for their own good reasons for years?"

If he were an individual investor, Gross adds, he would do this: “Balance your asset mix according to your age. Own more stocks if you are young, but more bonds if you are in your 60s, like myself. If you choose an investment advisor, a mutual fund, or an ETF, make sure that your fees are minimized. After all, if overall returns average 3% to 4% annually, how can you possibly afford to give 100 basis points of it back? You cannot. And be careful. The age of credit expansion which led to double-digit portfolio returns is over. The age of inflation is upon us, which typically provides a headwind, not a tailwind, to securities price—both stocks and bonds.”

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